Contracts for difference (CFDs) are a near-perfect route into the markets for those who wish to trade financial assets rather than own them. Each CFD is, as the name suggests, a contract between the trader and CFD provider, usually, a broker.
The trader takes a view on whether the asset in question – a share, a currency, an index or anything else – will rise or fall in value over a certain period. The broker, essentially, stands on the other side of the trade. At the end of the contract period, one party – whichever made the best judgment as to the direction of the price – will receive from the other the difference between the opening and closing price.
As the trader never owned the capital asset, how can any gain be taxed? But less well-understood is how CFD trading is paid for. Are there fees. Are there commissions? What should a novice CFD trader look out for?
Spreads and fees
The first thing to bear in mind is that the answers to these questions vary enormously, across brokers, across different markets and in relation to different assets.
In some cases, there are no charges at all for day trading, with the broker making its profit solely on the difference between the buying and selling price - the “spread”.
More on that in a moment.
The most obvious is a commission or fee on the value of the underlying security being traded. The size of this can vary a lot, from 0.1% to perhaps 0.3%, or more. Fortunately, this is a very competitive market, so the ability of brokers to charge steep commissions is severely limited.
If a commission is charged, it will usually apply to all instruments, including the trading of indices.
The second way in which traders pay a broker is through the spread, as mentioned earlier. This difference between buying and selling prices means, in effect, that a trader’s position has to move a number of points in what is, from the trader’s point of view, the “right” direction before they could even sell the contract back for the price they had paid.
When a broker both charges commission and operates a spread, the trader needs to take full account of both because it is in the interplay of the two that most of the real cost of the trade will be found. Low commission may disguise wide spreads, and vice versa. The total cost is the important figure.
One charge common to all CFD brokers comes into play when a position is left open overnight, even if it is opened a few minutes before midnight and closed a few minutes after. This “overnight premium” usually varies from one asset to another and is normally set at a pre-agreed level above a benchmark such as the London Inter Bank Offered Rate (LIBOR), typically about 2%.
As to why this overnight premium is levied, the answer is that a CFD, being a derivative, allows traders to take a position while paying only a small fraction of the value of the underlying security. In effect, the CFD trader is trading on margin, thus an interest rate is payable.