Institutions have used Contracts for Difference (CFDs) to limit their exposure to losses and increase their potential gains for many years. In today’s volatile markets, they are also becoming a valuable addition to the private investor’s strategy. The main use of CFDs is speculative, but many investors now use them as a tool for protecting their portfolios.
For knowledgeable investors, CFDs offer a quick, flexible and cost-effective way to speculate on whether an investment will go up or down. This guide provides an overview of the basics.
Please remember that CFDs are a leveraged product and may result in substantial losses that quickly exceed your initial deposit. They may not be suitable for all investors, so please be aware of the risks.
What are CFDs and how do they work?
A CFD is an agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price, multiplied by the number of CFDs specified within the contract.
CFDs work in a similar way to share dealing, except that although CFDs replicate the price movement of the underlying share, the investor does not own the physical share as they would do in a traditional share trade.
Who should consider using CFDs?
As a leveraged product, CFD trading can result in significant profits or losses beyond their initial investment; this exposure to a higher degree of risk is not suitable for everyone and we ask that you fully understand the risks associated with CFD trading before proceeding.
How can CFDs leverage an investment?
With CFDs, investors only need to put down a fraction of the value of the trade, which is then leveraged up to equal the equivalent trade in equities. Typically this is 10%, although it can be lower than this for more liquid equities (i.e. Vodafone).
This means that investors can make more, whilst putting down less money as they can often trade several times the size of their deposit; but of course it is important to remember that they can also lose more. Profits or losses can quickly exceed the initial deposit.
How can CFDs be combined with traditional share dealing to reduce risk?
Investors can use CFDs to reduce the risk of unexpected market movements. For example, you may have a long term share portfolio that you know you want to keep hold of, but you are worried that it may lose value in the short term, because you think the markets are heading down. You can take out a CFD that could profit on a drop in the share price and help offset the loss on the physical holding. At the same time this move might assist you in making a long term gain. This technique is called ‘hedging’ and is a major investment strategy used by experienced investors alongside their equity portfolios.
Why invest in CFDs?
There are a number of reasons for the increased popularity of CFDs.
1. CFDs can work out more cost effective than other ways of investing in equities and allow experienced investors to deal in larger sizes than conventional trading through ‘leverage’. Leverage allows investors to multiply their investment; trading larger sizes for a smaller outlay than traditional share dealing where normally you have to pay for the entire trade.
2. They have the potential to make money when going up, and unlike traditional share dealing, CFDs can also make money when going down (assuming you have traded in the right direction) – known as “going short”.
3. Also unlike spread bets, CFDs have no set expiry date, so investors have even more flexibility. Timescales for trades can vary greatly from hours, days and months; it really depends what the end goal of the specific trade is.
What are the advantages and disadvantages of holding a CFD rather than a share?
One area that is beneficial with CFDs alongside shares, is that you do receive the dividend that is payable from the relevant company that you hold a “long” position in. On top of that, you receive the dividend into your CFD account the day after the stock goes ex-dividend. In normal circumstances whilst holding the physical equity the payment date for your dividend to the registered holder of the share is 3 to 4 weeks. Alongside this there are various trading strategies that can be incorporated for one to benefit from taking the dividend. Conversely, if you were in a “short” position you would have to pay the dividend on the Ex-Dividend date.
CFDs don’t allow investors to collect the benefits to which they would normally be entitled by actually owning the shares. For example, investors won’t get an invite to the company’s annual meeting, or get to vote on shareholder issues because with a CFD you do not own the underlying share.
How can CFDs be used to make money when markets go down?
CFDs allow investors to place a ‘short’ on an investment, which means they may make money if a share price or market goes down. This allows investors to profit in a falling market, which is rarely possible with conventional share trading.
What are the tax implications of CFDs?
UK stamp duty does not currently apply to CFDs. This can mean a saving of 0.5% in the case of CFDs compared with ordinary UK shares. If an investor has a holding of physical shares they can sell CFDs against this, without crystallising a potentially taxable capital gain. This gives the investor control over the time at which point capital gains or losses can be crystallised and may help reduce their tax liability. As always, investors should be aware that tax laws can change.
Where can CFDs be placed?
CFDs can be placed on a wide range of global markets including shares, indices, commodities and currencies. For more information about tradeable instruments, speak to one of our CFD brokers on 020 7382 8383. Click here for more information about our Advisory CFD service.
Are there ways of limiting risk?
Where available, investors can use stop losses to automatically close a position if it falls and thus limit losses. HB Markets’ CFD brokers can advise you on a number of ways to limit your risk when trading CFDs.
Are CFD trades instantly executed?
Yes, CFD trades with HB Markets are immediately executed. You can execute your CFD trades in one of two ways; firstly you can trade in a traditional way by calling our broking desk or alternatively you can execute electronically via our online trading platform. UK CFDs are available to trade between 8:00am and 9:00pm (Mon - Fri). FX and Index trades are available via the platform 24 hours a day (Mon - Fri).
Risk Warning
This information does not constitute advice or a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. You are recommended to seek advice concerning suitability from your investment advisor. Investors should be aware that past performance is not necessarily a guide to the future and that the price of shares, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. Contracts for Difference (CFDs) carry a high level of risk to your capital. It is possible to lose more than your initial investment. There is an extra risk of losing money when shares are bought in some smaller companies including “penny shares”. There can be a big difference between the buying price and the selling price of these shares and if they have to be sold immediately, you may get back much less than you paid for them or in some circumstances, it may be difficult to sell at any price. It may also be difficult for you to obtain reliable information about the value of this investment or the extent of the risks to which it is exposed. Where a company has chosen to borrow money (gearing) as part of its business strategy its share price may become more volatile and subject to sudden and large falls. This type of investment may not be suitable for all investors, and you should carefully consider your own personal financial circumstances before dealing in the stock market, particularly if on a fixed income or approaching retirement age.
© HB Markets Plc - July 2011
