In the world of finance there is a myriad of ways to make money – provided that you know what you are doing, have a reasonable capital stake and have a healthy dose of good fortune. But there are ways of trading and making the same amount of money with considerably less outlay. A CFD – contract for difference – is one such method.
A CFD is a derivative product that allows you to trade on market movements without actually owning the product. It is merely a contract between you and the broker to exchange the difference between the opening and closing prices of a contract. You can speculate on market movements in either direction – up or down.
CFD trading is conducted in a similar way to share trading through providers like Capital Spreads and the price quoted is usually the same as that of the underlying share. It is important to be aware that losses may exceed your deposits. CFDs, however, offer several advantages:
- In the United Kingdom there is no stamp duty.
- They can be traded long or short allowing you to take advantage whichever way the market moves.
- They are traded on a margin, meaning that you can make a similar profit (or loss) on a trade as you could with the underlying share but with significantly less outlay.
- You can access a greater range of financial markets.
- You can control your risk by using stop loss and limit orders.
They also carry some disadvantages:
- Commission has to be paid in the same way it is paid on ordinary shares.
- CFDs held overnight attract finance charges. Long positions are subject to interest charges if held overnight while short positions receive interest.
- You are not a shareholder and therefore have no shareholder rights.
- Unless you properly manage stop loss orders, you could expose yourself to considerable losses if your position moves the wrong way.
- You must ensure that you maintain sufficient money in your account to cover the margin if your position moves beyond the allowable limit. If not you will either have to deposit more funds – a margin call – or your position will be closed and you will be liable for the loss.
CFDs work very simply. If you believe that a particular share will rise then you buy a contract at the sell price for a given number of shares as a CFD. Speculating on a rise is called a long trade. You only pay a percentage of the share price as a deposit (initial margin).
If the price goes up, you sell and make your profit. On the other hand, if it goes down, then you will make a loss. If you believe the share price will fall, then you take a short position and profit when the price goes down.
Some investors use CFDs to hedge their positions. Say, for example, you have shares that you fear will lose value. You sell some at the current price and use part of the proceeds to buy the equivalent number of CFDs on a short basis. Should your share fall, any losses will be made up by the profits from your CFDs. Similarly, CFDs are useful if you have shares that you think will go up in value but you have to liquidate some to meet pressing financial needs. By taking a portion of the proceeds and purchasing the equivalent number of long CFDs, if the price does go up, the increase in value of your CFDs will offset what you lost by having to sell your shares.
You can find out more about CFDs from reputable companies like Capital Spreads, which offer tutorials, facilitate trades and host seminar sessions for beginners.
Full Risk Warning – Spread betting and CFD trading carry a high level of risk to your capital and can result in losses that exceed your initial deposit. They may not be suitable for everyone, so please ensure that you fully understand the risks involved.
About the Author: Chris James. I am a freelance finance writer with a particular interest in spread betting and CFD trading.