Winning both ways with CFDs

An overview of the increasingly popular investment.

Originally published in Investment Adviser, 21st May 2007.

Stock market volatility makes Contracts for Difference (CFDs) an especially valuable tool for investors as their ability to sell short means investors can speculate and profit from falling share prices.  This versatile product is no longer in the exclusive domain of institutional investment houses.

What is a CFD?

CFDs have an image of being complicated, but they are actually based on a very simple concept.  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 follow the price movement of the underlying share, commodity or indices, but crucially the investor does not buy or sell the physical asset as they would do in a traditional share trade. As the investor is only exchanging the difference, the amount that is invested can be magnified through ‘leverage’, using a small deposit to magnify the trade size by up to 30 times, to enhance potential profit size dramatically.

Increasingly popular with private investors

Traditionally only the major banks and funds used CFDs to limit their exposure to losses and open up larger potential gains than possible through traditional equity trading, but private investors are now increasingly using CFDs in the same way. It is estimated that up to 40 per cent of the daily trades on the London Stock Exchange are now from CFDs, compared to 10 per cent five years ago.

How CFDs are used by institutions

For example, a fund holding an amount of one large stock bought for £1 million could be hoping for it to rise and sell for perhaps a 5 per cent increase, being a profit of £50,000.  However they would take out a CFD that protected them if the stock dropped, i.e. a ‘hedge’.  CFDs work well here as a large stock may only require a much smaller outlay than the equity purchase to cover the whole amount due to leverage. For example 30 times leverage equates to only £33,000 outlay to cover the £1 million value. 

In this instance if the equity itself rises and the CFD therefore becomes a loss, the fund can close the CFD and limit the loss by using a stop loss order.  If the equity itself drops badly then the CFD becomes profitable and can quickly make a substantial profit through the leverage.  Either way the fund wins and managed correctly CFDs can be very profitable.

It is this sophisticated management of investment strategies that has switched experienced share traders onto CFDs. They offer a quick, flexible and cost effective way to speculate on whether an investment will go up or down and investors do not have to buy the underlying asset so it does not tie up all their investment capital.

Who should invest in CFDs?

CFDs are not suitable for all investors, as these larger deals have the potential for larger or unlimited losses as well as larger gains.

That said, used in the right way CFDs can be a great investment tool. They have the potential to make money when going up and unlike traditional share dealing CFDs can also make money when going down. Also CFDs have no set expiry date, so investors have even more flexibility than with Spread Trading for example.

CFDs are also exempt from Stamp Duty of 0.5 per cent on UK equity purchases and are therefore very cheap to trade frequently due to lower costs. But like other investment types the uses of CFDs vary depending on an investor’s individual circumstances and investment outlook.  Profits from CFD trading are liable for Capital Gains Tax , whereas Spread Trading is not, so individuals such as active traders and hedgers are attracted to CFDs instead of Spread Trading because of the possibility of offseting losses against tax on any gains.

CFDs are therefore not for everyone and investors need to understand how CFDs work before investing.

How can CFDs be combined with traditional share dealing to reduce risk?

Investors can use CFDs to reduce the risk of unexpected market movements devaluing their equity investments.

For example, a client may have a long-term share holding that they want to keep hold of, but are worried that it may lose value in the short term. In this circumstance the investor can take out a CFD that could make money on a drop in the share and help mitigate the loss on the actual share held. At the same time this move might assist making a long term gain.

Are there any disadvantages to holding a CFD rather than a share?

CFDs do not allow investors to pick up the perks that they would get from 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. 

Are there ways of limiting risk?

Where available, investors can use a limited risk account where the size and exposure is limited and stop losses automatically close out a position if it falls and thus limit losses.