Investing Basics: What are CFDs?
A Contract for Difference (CFDs) is an agreement between two parties, typically the ‘buyer’ and the ‘seller’, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time (If the difference is negative, then the buyer pays the seller) – by Christian Leeming.
CFDs can be used to trade and speculate on the price movements of thousands of financial markets regardless of whether prices are rising or falling.
CFDs are derivative products that allow the purchaser to trade on movements in the price of an underlying asset without ever owning it.
When applied to an individual share, the CFD is essentially an equity derivative; instead of buying 100 shares in Acme Co, you may decide to buy 100 CFDs ‘in’ the same stock.
Purchasing the shares will attract a dealing commission and stamp duty, whereas CFDs are traded on margin meaning that the buyer may have to lodge only a fraction of the price that would have been needed to buy the stock outright.
‘they do not attract stamp duty, thereby immediately saving 0.5% when the trade is opened’
Most providers charge commission on CFD trades based on equities but they do not attract stamp duty, thereby immediately saving 0.5% when the trade is opened.
For every day the trade is open the broker will normally levy a financing charge to reflect the cost of the leveraged position that has been created; essentially the broker is lending you the difference between the margin payment you have made and the exposure to the stock created by the contract.
As interest rates remain low the cost of financing a CFD is also low as it is based upon LIBOR and most CFDs can remain open for as long as the buyer wishes.
Once the contract has been agreed, the price of the CFD will move up and down in line with the underlying market and unlike other derivative products the pricing always relates directly to the value of the underlying asset which means that CFDs may be used instead of more traditional methods for benefits such as margin trading.
CFDs and spread betting are often bracketed as delivering a choice for investors although there are some differences – spread betting is tax free whereas CFDs do attract capital gains tax.
Relative to spread betting, CFDs have declined in popularity but their inherent transparency means that they can still be used to provide an effective hedge to a portfolio; in this instance any losses made on the losing side of a hedge can be offset against CGT liabilities arising elsewhere.