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.
Thus, large positions can be built up using relatively small sums of money. Should the trader have correctly called the various price movements on which they are trading, their gains will be greatly magnified – their profit will greatly outweigh their initial stake.
In short, margin trading is a double-edged sword. But it does allow someone of limited means to back their convictions without committing all their capital.
A second benefit relates to cost and flexibility. A CFD account can, usually, be opened at considerably less cost than would be the case with a conventional trading account with a stockbroker. Furthermore, it is likely to take a fraction of the time that would be involved in establishing an account with a stockbroker.
Tailor-made for those with strong convictions
Once you have started trading in the CFD market, you have the flexibility to take long or short positions, and you are dealing on live prices in real time, with no delays in terms of the order being filled.
The tax treatment of CFDs provides a third benefit. Share transactions attract Stamp Duty of 0.5% of the value of the deal in the UK and 1% in Ireland. But while CFDs offer many of the benefits of share ownership and other marketable securities, they do not qualify for Stamp Duty.
They do, however, qualify for Capital Gains Tax (CGT) in the UK, despite not being, in conventional terms, a capital asset. But CGT is not paid unless and until the trader has exhausted their annual allowance, currently £11,700.
Those are the advantages. But, are there any disadvantages?
We’ve touched already on the absence of voting rights, in the case of equity market CFDs, and mentioned also that margin trading, while allowing you to win a lot more than your initial stake, allows you also to lose a lot more if the trade goes wrong.
All that said, CFD trading is a relatively inexpensive, flexible and tax efficient way to back your convictions in the market without committing huge amounts of capital. Yes, there can be losses, but there is also the inexpressible thrill that comes from having been proved right.