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You Are Here: Home > Stockmarket & Trading > CFD Section > CFD Guide > 5 minute guide to CFDs
5 Minute Guide To CFDs
Contracts for Difference, normally always called CFDs, are margined products used to trade mainly equities on UK, European and US markets.

CFDs can also be used to short sell and are therefore extremely versatile products.

So it's no wonder that these products have taken the financial markets by storm over the last 10 years. They are now used by all market participants, whether small-time punters or the largest of hedge funds.

How do CFDs work
Trading CFDs is the same as buying or selling a share using a traditional stockbroker But they are margined products and therefore use borrowed money, for example -
  • Buy 1,000 shares (not using CFDs) of ABC Industries at £1.00 a share using a traditional style stockbroker and you'll have to pay the full £1,000 (excluding commissions and costs)
  • However, if you buy the same position using CFDs you will only have to deposit an initial margin payment of between 5% and 20% of the deal size, with the balance being lent to you (see below for more information)

Leverage with CFDs means 2 things -

  1. Profits and losses are multiplied on the amount of money used to take out the position, and
  2. Small amounts of money can control large trading positions
CFDs can be used to short the market
CFDs are designed to be flexible and they can be used both to buy the market, often called going long, as well as to sell the market, often called going short, ie being able to profit from declining prices.

If you are not sure what shorting is or how it works, see this LearnMoney.co.uk link.

CFD Financing
When CFD clients are lent money they incur a financing charge, usually 2% + LIBOR (London Interbank Offered rate), for example -
  • Buy £10,000 of shares using CFDs
  • Your broker will ask for an initial deposit of between 5% - 20% (usually the bigger the share the lower the deposit, so BT at 5% and the 'Tiny Internet Firm Inc' at 20%) - More information on CFD margining
  • However, even though you've paid a deposit the broker will normally charge you interest on the full £10,000
  • If the financing charge is 2% + LIBOR and LIBOR is at 3%, a yearly rate of 5% will be charge
  • But this is payable on an overnight basis, for example -

5% of £10,000 is £500 / 365 days = An overnight financing charge of £1.37

Note that for day trading positions there's no financing charge as the CFD position is obviously not held overnight.
A CFD trade example
  • You're bullish on Vodafone thinking the stock will move sharply higher over the next week
  • On Monday you buy 10,000 shares at £1.20 using CFDs
  • The following Friday you sell the position at £1.30
CFD - Long position in Vodafone
Buy 10,000 Vodafone shares using CFDs at £1.20
10% cash deposit (refundable) (£1,200)
Commission at 0.2% (to open)
(£24)
Financing (4 days at £2.30 per day)
(£9.20)
10,000 Vodafone shares sold at £1.30 - Profit
£1,200
Commission at 0.2% (to close)
(£26)
TOTAL PROFIT
£1,140.80
Financing works differently for short positions
Whereas as long CFD positions (buying stock expecting higher prices) have to pay an overnight financing charge, short CFD positions receive a cash credit. This is because the short trader is theoretically lending stock to the market.

The short position will receive interest usually at LIBOR - 2% so it's hardly anything to get excited about. More information on how the financing works on short CFD positions on this link.

CFD commissions and charges
Commissions are competitive in the CFD world and expect to pay between 0.1% - 0.2% of the total deal size for buying and selling. Most brokers though will insist on a minimum commission, usually £10 - £25.

Another benefit that CFDs carry is that stamp Duty at 0.50% is not levied and this can help the short term trader cut costs dramatically.

Interesting point

Because of the financing as a general rule of thumb a long CFD position starts to get expensive if held for more than 1 month. The cheaper option if looking to hold shares for many months is to buy them using cash rather than using CFDs.

In summary CFDs are best used for short and medium term trading, from day trading to holding a position for a few weeks or up to a month.

CFD advantages
  • Leverage - £1,000 in cash can control a trading position up to £20,000

  • Go long or short - Flexible products are always the best

  • No Stamp Duty levied - Saves 0.5% per trade, which can really add up over a year

  • Trade equities and indexes - CFDs are mainly used to trade equities but they're also available on stock indexes

  • Tight bid-offer spreads - Unlike spread bets the bid-offers are a lot tighter with CFDs and that helps to cut costs

  • Low commissions - Between 0.1% and 0.2% is a hell of a deal for traders, especially active ones

  • Ability to place stop losses - Buy shares (not using CFDs) and it's not easy to place stop losses, but with CFDs it's simple because most brokers offer their clients sophisticated online trading platforms
Disadvantages
  • Leverage - It was listed above as an advantage but it can also be a disadvantage. Leverage is like fire, your best friend but it can turn out to be a nasty enemy. Take on too much leverage and even a small move of 5% in a stock can result in heavy losses

  • Financing - Can get expensive if CFDs are held for more than 1 month, they're better suited therefore to short and medium term trading, anywhere from 1 day to 1 month

  • Tax is levied - Unlike spread bets, tax is charged on CFD profits above your personal Capital Gains Tax limit
How and where to open an account
There are about 12 dedicated CFD brokers specialising in retail clients. These are split into 2 different styles -
  1. Direct Market Access brokers, and
  2. Commission Free CFD brokers

So what's the difference?

Direct Market Access Brokers (DMA)
These offer the same dealing prices as if trading the shares via an official exchange. So whether you buy 1,000 Barclays through a traditional stockbroker (not using CFDs) or buy the same position via CFDs, the dealing price quoted will be the same.

Note that DMA brokers all charge commissions.

Commission Free CFD brokers
As the name suggest they charge zero commission but then offer their own independent dealing prices which are usually similar if not the same as the ones quoted on the official exchange.

So which style of broker is the best?

Often the trick is to see who the professional traders use and the majority of them will use a DMA style broker even though they charge commissions. The reason for this is it's normally always better (and cheaper) to trade on a price determined by many market participants rather than just one.

LearnMoney.co.uk comment:
CFDs offer the stockmarket trader 3 distinct advantages -
  1. Leverage - £10k cash can be used to trade up to £100k in stock, sometimes even higher
  2. Shorting - Profit from declining prices
  3. Cost efficient - commissions are usually competitive, plus most CFDs deal at the same bid-offer as the cash market unlike spread betting where spread bet brokers will quote their own dealing prices

However like any financial product that offers leverage CFDs can't be treated lightly as the leverage can result in both quick and heavy losses.

But for traders who are sensible, and who fully understand how both CFDs and the stockmarket works as well as the potential threat leverage poses, there's probably no better product for speculating on the stockmarket.

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