In a relatively short period of time, contracts for difference have become a favourite vehicle for day traders and others. Those keen to back their view of the likely performance of a stock, currency, commodity or index can do so in a way that is generally faster, cheaper and more flexible than would be the case if they have to acquire the underlying asset.
There is also a tax advantage to trading CFDs in the UK and Ireland. More on that in a moment.
First, a look at the key difference between trading CFDs and the assets they represent. Buying a share or any other security involves taking ownership of that asset. A CFD, by contrast, as the name suggests, is a contract with a CFD provider, usually a broker, in which both parties agree to pay the difference in the price at the start of the contract and its end-date.
Essentially a trading vehicle
Thus, a trader who believes a share is going to rise will take out a “long” position with the broker. If they are right, the broker will pay them the “difference”, in this case the amount by which the price has increased.
However, if they are wrong, it will be the trader who pays the broker, in this case the amount by which the share – or any other asset – has fallen.
In the same way, a trader who believes a security is going to fall will enter a “short” contract with the broker. If proved right, they will be paid the amount by which the security has declined, and, if wrong, will pay the broker the amount by which it has risen.
Clearly, CFDs would not suit the sort of market player who enjoys attending shareholder meetings or likes to frame their share certificates. It ought to go without saying that CFDs are, at root, a trading vehicle, rather than a means of making long-term investments.
Chance of big gains – and losses
But for someone who is a trader rather than an investor, they offer a number of key benefits.
The first is the ability to trade on margin. Now, a lot of would-be traders find talk of “margin”, “leverage”, “gearing” and the rest more than a little off-putting. But at its heart, it is a simple concept.
Instead of tying up all your capital in a market position in stocks, or commodities or any other asset, the trader lodges a deposit with the CFD provider and is able to use this deposit to buy CFDs worth a great deal more than the deposit itself. Typically, a trader would be required to pay up-front somewhere between 5% and 20% of the contract value, freeing up capital for other trades.