Contracts for Difference were once only available to major institutions. Private investors are now taking advantage of the opportunities this product offers.
Major banks and hedge funds use CFDs to limit their exposure to losses and for opening up larger potential gains than may be possible through traditional equity trading. Private investors are now increasingly using CFDs in the same way, which has led to them becoming one of the world’s fastest growing ways to trade thefinancial markets.*
For knowledgeable investors, CFDs offer a quick, flexible and cost effective way to speculate on whether an investment will go up or down. These guidelines will help those who may be interested in CFDs by providing an overview of the basics.
* CMC Markets UK Plc, July 2008
Please remember that CFDs are a leveraged product and may result in substantial losses that quickly exceed your initial deposit.
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.
Why invest in CFDs?
There are a number of reasons for the increased popularity of CFDs. CFDs can work out cheaper than other ways of investing in equities and allow experienced investors to deal in bigger 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.
However, used in the right way CFDs can be a great investment. 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). Also unlike spread bets, CFDs have no set expiry date, so investors have even more flexibility.
CFDs are typically used for short term trading but like other investment types, the uses of CFDs vary depending on an investor’s individual circumstances and investment outlook.
Who are CFDs suitable for?
Many private investors are graduating to using CFDs in addition to their existing trading and investments. For UK taxpayers CFDs are potentially taxable, but individuals such as active traders and and hedgers are attracted to CFDs because of the possibility of offsetting losses against tax on any gains.
** tax laws may change
How can CFDs leverage an investment?
With CFDs investors only need to put down a fraction of the value of the trade. Typically this is 10 per cent, although it can be lower than this for liquid markets (i.e. investments with a lot of trading activity) such as for foreign exchange trades on currencies.
This means that investors can makemore, whilst putting down less money as they can trade often 10, 20 or 30 times the size of their deposit; but of course 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’ your risk and is a major investment strategy, used by experienced investors alongside their equity portfolios.
Are there any disadvantages to holding a CFD rather than a share?
CFDs don’t 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.
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. This 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 per cent, for example in the case of CFDs referenced to UK shares. As always, investors should be aware that tax laws can change.
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 capital gains or losses can be crystallised and may help reduce their tax liability.
Where can CFDs be placed?
CFDs can be placed on a wide range ofglobal markets including shares, indices, commodities and currencies. More information can be found on Hoodless Brennan’s trading website: www.hoodlessbrennanmarkets.com
Are there ways of limiting risk?
Where available, investors can use stop losses to automatically close out a position if it falls and thus limit losses. Hoodless Brennan CFD Brokers can advise you on a number of ways to limit your risk when trading CFDs.
Are CFD trades instantly executed?
CFD trades with Hoodless Brennan are immediately executed. You can execute your CFD trades in a variety of ways. You can trade in a traditional way bycalling our broking desk or execute electronically via our trading platform. UK CFDs are available to trade between 8:00am and 9:00pm. FX and Index trades are available via the platform 24 hours a day.
To find out more about trading CFDs with Hoodless Brennan on an Advisory and Execution-only basis telephone 020 7510 8607 or visit the CFD section of this website.
Hoodless Brennan Markets is a trading name of CMC Markets UK Plc who are authorised and regulated by the Financial Services Authority (173730). CFD services are provided by CMC Markets UK Plc trading as Hoodless Brennan Markets.
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