So how can you use Contracts for Difference (CFDs) in your trading?

There are two main ways -

1. Speculation
2. Hedging

And of course with the ability to easily short the market (profit from falling prices) using CFDs this opens many new tactics including what's known as Pairs Trading.

Other common strategies are listed below;

Flexibility: Profit from falling as well as rising markets

• Unlike physical shares, CFDs can be sold short so enabling one to profit from a decline in the market or an individual stock
  
  
• An introduction to selling short

Leverage: Magnify profit (or loss) potential

• CFDs allow sophisticated investors to back an investment view on a geared exposure basis
  
  
• A £10,000 account can trade up to £100,000 in shares
  
  
• Leverage should always be used wisely for it is both a trader's best friend and worst enemy
  
  
• It is strongly advised (see bottom of the page) that people new to leveraged products like CFDs start trading in small amounts

Trade Discreetly:

• Equity CFD trades do not result in transfer of ownership of the shares, so the usual stock exchange disclosure rules do not apply, and the trades are not published
  
  
• If you're a corporate raider and are reading this, then CFDs are an excellent weapon in your armoury!

Risk Management: Hedge market exposure

• Perhaps you are an investor of a share for the long term but expect a short-term correction, either relating directly to the share or the overall market
  
  
• By using CFDs to short the stock your exposure can be reduced
  
  
• If you owned 5,000 shares in BT as a long term investment you could short 5,000 shares using CFDs
  
  
• But CFDs are as much about flexibility as anything else, so if mildly bearish you could short say just 2,000 shares and be part hedged

Tax Planning: Trade against profitable holdings

• Equity CFDs can be sold to lock in a profit on an equity holding without incurring a tax liability
  
  
• They can be used to mirror the old Bed & Breakfast type CGT trades even though the Treasury believes it has closed the loophole
  
  
• How to use derivatives for "Bed & Breakfast" tax trades in the stockmarket

Pairs Trading:

Pairs trading is a relatively simple concept to understand -

• One of the most common trading strategies in all the leveraged world (Futures, Options, FX, Commodities etc) is spread trading where one product is bought and another related product is simultaneously sold short
  
• The subtle point with these strategies is the overall direction of the market now becomes redundant
  
  
• The Pairs trader is simply trading the price difference of the two products
  
  
• Examples of spread trades in the futures market are buying Gold and selling short Silver, buying Corn and selling short Wheat etc
  
  
• Examples in the stockmarket would be buying BT and selling short Vodafone, or buying Shell and shorting BP

If you were to buy BT and sell Vodafone (usually done in the same monetary amounts, £5k long, £5k short) then it would be possible to make money whatever the underlying FTSE 100 does.

If the overall market rises by 25% then the Pairs trader is hoping that BT will outperform and Vodafone underperform. And if the market crashes you are forecasting that BT will fall say 20% while Vodafone falls 30%.

Another area where CFD traders like to get involved with Pairs Trading is where a stock is bought and the underlying index is sold short. This is again on the assumption that in either a falling or rising FTSE 100 the stock in question should outperform the general market. Buying £10,000 of Barclays Bank and selling £10,000 worth of the FTSE 100 index (using a CFD) is an example of this kind of trade.

Watch Commissions and Costs With Pairs Trading

An important point to consider with Pairs trading is that costs are doubled. This is because 2 stocks or indexes are being traded and costs will be levied on both.

Pairs trading is discussed in far more detail in the Spread Betting section.