Contracts for Difference (CFDs) provide an exciting way of benefiting from movement in the stock market without actually purchasing any shares.
This involves forming an agreement with a broker and committing to exchange the difference in value of specified shares between the opening and closing of a CFD.
The contract amount on closing, or the amount you'll earn, is dependent on the number of shares included and the rise or fall in share price.
What makes CFDs popular?
The popularity of CFDs is based on two distinguishing characteristics. The first being that CFDs can be used to predict decreases in share value as well as share increases. The second is that CFDs are based on margin trading.
Predicting shares go up or down
If an investor buys a CFD based on the prediction that the value of this stock will rise, it is known as 'going long'.
However, unlike traditional investments in the stock market, you are able to use CFD trading to benefit from a predicted decrease in stock value. This is known as 'going short' and involves the theoretical sale of shares that you don't actually own with the hope that the stock's value will decrease and you will be able to buy them back at a reduced price, making a profit from their fall in value.
This feature makes CFDs trading a more versatile form of growing your investment, especially as it is possible to use them to hedge against the decrease in value of shares you actually own.
Because of the dynamic nature CFD trading investors often use a CFD online trading platform to manage their contracts. Some of the best CFD brokers can be found on such trading platforms, so investments are immediate and amendable.
What is margin trading?
CFDs are based on margin trading which means that unlike traditional investments, you only have to deposit a percentage of the value of the contract (usually 10%), although you must be able to demonstrate to the broker that you have the funds in place to cover the rest of the contract, should the share movement go against your prediction.
As you haven't had to put down the whole contract amount you are able to take a bolder position, potentially resulting in a far greater growth in capital compared to your initial deposit.
However, although the benefits of your investment can be multiplied using CFD margin trading, you are also at greater risk of losing more than your initial investment if your prediction is incorrect.
Due to the nature of CFD trading your capital is not secure and it is a very real possibility that you will lose more than you put into the contract, making CFD trading a high risk form of investment only suitable for experienced investors.
How can you control the risk?
Mechanisms such as stop loss orders can be put in place to minimise the risk of a huge loss; these act to automatically end the contract if it moves below a specified loss making position.
While there is often a charge imposed by the broker if a stop loss order is included in the contract it could prove invaluable in protecting your money against heavy losses.
Finding the best CFD broker is often a compromise between the amount of risk / potential profit that you want, and the broker's fees and interest rates.
What are the best CFD strategies?
There are many different ways in which you can make use of contracts for differences. One popular strategy is to use them as a way of hedging against risk. Say you are worried the value of your portfolio may fall and particularly the value of a certain company.
You can guard against this by taking what's known as a short position on that company. This means you'll still benefit if the price rises, but you'll also get compensated should it fall.
Alternatively, if you're convinced that company is going to take off you could double up your position by going long. If that company experiences a sudden surge in share price, your profits could be hugely magnified.
Likewise, if it collapses you could be left with a substantial debt to pay.
Contracts for differences brokers
Because of the complexity and risks involved it's important to pick a broker who knows what they're doing.
They should work with you and make an assessment about whether you fully understand what you're getting yourself into.
Some contracts for difference brokers will offer a 24 hour service which allows you to make trades at any time of the day or night. This is useful as it means you will not be quite so exposed should the market move suddenly over night.
You can compare the different options available using our CFD comparison table.
What charges do you pay?
There are several different charges associated with investing in CFDs - to start with you are likely to be charged an arrangement fee by your broker.
Secondly, if you hold a CFD overnight you are likely to be charged interest; for this reason CFDs tend to be more suitable as a very short term investment.
When dealing with CFD brokers UK wide, you will also be liable to pay Capital Gains Tax on your profits, although unlike regular shares you do not have to pay stamp duty on your transactions.
As Contracts for Difference use margin trading, enable you to profit from highs and lows in the stock market and give you access to a wide range of investment opportunities, they can make for fantastic profits.
However, they can also result in large losses so you should only ever consider entering a CFD if you have other secure financial provisions in place, have money available to fulfil the rest of the contract if the share value moves in the opposite direction to your prediction and fully understand the implications and risks associated.