Although individual Stock Index futures have been available for many years, CFDs are still a relatively new concept for the non-institutional trader, bearing similar properties to futures contracts but with no expiry.

CFD's are proving to be one of the more popular ways of providing flexible and cost effective exposure to individual equities without having to trade in the underlying share.

CFD's, are at present revolutionising the way that we both trade and look at equities. Now the individual can enjoy not only the flexibility that CFD's offer but can also take advantage of leverage and its benefits.

CFD stands for Contract for Difference.

Essentially, a CFD is an agreement with a provider to exchange the difference between the prices of an underlying financial instrument at the point when you entered the trade and at the point when you exited the trade. Rather than buying and selling in that physical market, the CFD mirrors the price and—when the CFD is closed— you make or lose exactly the same amount as if you were trading the underlying market.

One of the benefits of CFDs is that they can be used to take advantage of both rising and falling markets. Because a CFD is merely a speculation on the price movement of an underlying asset, it does not require ownership of the asset, and therefore you can enter the market by either buying or selling.

CFDs have been used since the early 1990s by financial institutions to hedge their portfolios against adverse movements in the markets and also to make use of leverage. Around the turn of the century, private investors also began trading CFDs, thanks to online financial dealers helping to make the product more accessible. Its popularity has become so widespread that you now can trade thousands of different markets as a CFD, including equities, indices, currencies, commodities, bonds, and interest rate futures.

Main Benefits

• Flexibility - Trade short as easily as long, trade CFD's on UK and European stocks down to a market capitilisation of £10 million, and all major US (incl. Nasdaq)
• Cost - Typically, 0.5%, No Stamp Duty. Because CFDs are based on prices and nothing is actually exchanged, you can avoid the costs that come with physical ownership of an asset. With less coming off of the top of each CFD, you can afford to make more trades and move in and out of the markets with relative ease.
• No settlement period - both long/short trades can be kept open indefinitely (dependent on margin requirements).
• Receive 90% of dividends on long CFD's. You can keep your CFDs open for as long as you like. It is your decision whether to exit or hold onto a trade.
• Leverage - Typically 10-1 leverage on most FTSE 100 stocks. £10,000 controls a nominal value of £100,000. Leverage allows you to trade larger positions with less money. With a leverage of 100:1, you will receive $100 worth of market exposure for each dollar you invest in a CFD trade. This allows you to have the full dollar amount exposure ($100) without tying up the full $100 of your capital. You would only require $1 to hold the $100 trade, leaving you with $99 to either invest elsewhere or increase your exposure. The decision to increase your exposure still needs to remain within your risk tolerance profile as it would if you were trading the underlying market directly. For traders looking to over leverage their trades relative to their account size, they do have the opportunity to see a much higher profit gain in a shorter time period, especially compared to other forms of trading. However, those same elements that have traders overleveraging their CFD trades looking for large profits can also lead to deeper losses than would be possible without the use of leverage.
• Risk Management - Hedge your risk, manage CGT liabilities. CFDs can be an effective way to hedge your portfolio. For example, if you are concerned that the stock market is due for a sell-off, you can protect your share portfolio by short selling CFDs. In this way, you can protect yourself without going through the expense and inconvenience of liquidating your stock holdings.
• Direct access to the SETS order book.

What are CFDs?

CFDs can be defined as contracts designed to make a profit or avoid a loss by reference to movements in the price of an item, where the underlying item does not change hands. CFDs were developed to allow clients to receive benefits of owning stock without actually having to physically own it.

How CFDs work

Because you can speculate on whether a market's price is going to move up or down, CFDs are always quoted with two prices.

The Bid: the price at which the buyers are willing to buy.

The Offer: the price at which the sellers are willing to sell.

As a trader of CFDs, you need to execute on either the bid price or the offer price. If you expect that the price will fall, you sell at the bid price. If you believe that the price will rise, then you buy at the offer price.

The difference between the bid price and the offer price is called the spread.

For equities, one CFD is equivalent to one share. For a shares index, such as the AUS200, one CFD is equivalent to one contract of the AUS200. For other instruments, it varies. For example, when trading gold, buying or selling one CFD means that for each one-point change in the price of gold, your CFD position will gain or lose one U.S. dollar. If the gold price moves from 1650 to 1651 and you hold one CFD contract, then you have made US$1.

Buying and selling, based on the performance of a share through a CFD, is almost identical to a physical equity trade financed by a loan. For example, a client could borrow £10,000 from a Bank to buy shares. The client would receive the returns from the shares, but would pay interest on the loan to the Bank. CFD's combine this process in a single transaction.

For example, if a client wants to buy £10,000 of Vodafone he would have to deposit with a CFD provider. £1,000 (10% margin) before being able to do this. If the client wanted to keep the position overnight they would be subject to overnight financing charges on the trade. On the other hand, if a client holds a short position he receives overnight financing charges. If a CFD position is not carried overnight there will be no financing charge to pay. Also as the client is trading a CFD and not the underlying physical share there will be NO Stamp duty to pay.

Another major benefit of trading a CFD is that the client can trade on margin. CFD trading means clients can trade a full portfolio of shares without having to tie up large amounts of capital.

CFD's enable clients to short sell stock as well. Short selling shares, or benefiting from a fall in price has long been the advantage of the bigger Institutions. Individual clients can now enjoy the total flexibility that short CFDs offer.

Equity Performance

As with shares, CFD investors benefit from normal market movements. Buyers will benefit if the value of the contract/shares increases, similarly, a short seller will benefit from any fall in value. The holder of a long/short CFD can close his position any time during regular stock market hours.

Clients' open positions are valued every night at the close of business. Profits or losses will be credited/debited to the client's margin account each day. Corporate actions are applied to the client's account when they occur. Clients receive 90% of the gross dividend the day after the company goes ex-dividend, or pays 100% of the gross dividend if he has a short position in the stock, when it goes ex-dividend.

Trading and Equity CFD

Let's say that Australian company XYZ has a dealing quote of 124/124.1. The quote is in cents, so the quote may also be read as $1.24/$1.25. You would sell at the bid price ($1.24) or you would buy at the offer price ($1.25). The spread is the difference between the two prices, which in this example is 1 cent.

Let's say you expect the share price to rise and you decide to use CFDs rather than traditional share dealing to back your view. You buy at $1.24.

BUY PRICE [$1.25] - SELL PRICE [$1.55] = (PROFIT/LOSS) [30 cents].

For equities, one CFD is equal to one share. If you had bought and sold one CFD, this would be the same as buying and then selling a single share. So, buying and selling one CFD in this example would give you a profit of 30 cents. If you bought and sold 200 CFDs, which is the same exposure as holding 200 shares in the underlying market, then your profit would be $60.

200 x 30 CENTS = $60.

CFD Markets

Individual Equities: CFDs on individual equities are one of the most popular types of CFDs. They offer you the opportunity to trade on the price movements of shares without the costs and restrictions usually associated with ownership. Trade on BHP Biliton, the Rio Tinto Group, and more.

Indices: Why trade one share when you can buy or sell an entire stock index? Trade the UK100, Germany 30, AUS200, and many other global indices as either a spot or futures CFD.

Commodities: CFDs on commodity products allow you to take advantage of the price movements of such diverse markets as gold, platinum, oil, cocoa, corn, or sugar. Most commodity CFDs are based on exchange based futures markets. However, spot contracts are available on gold, silver, and oil.

Bonds and Interest Rates: Government bonds are one of the most highly traded financial futures instruments. Interest rate futures are closely linked to government bonds. You can use CFDs on many of the most popular bonds and interest rate futures, such as German Bunds, UK Gilts, and U.S. Treasury bonds, notes, and bills.

Foreign Exchange (Forex): You can trade over 120 currency pairs with a forex CFD, from majors such as EUR/USD to exotic and emerging pairs such as USD/INR.

Glossary

Contract for Difference (CFD): A trading vehicle that gives you the opportunity to speculate on the price movement of a particular financial market or instrument.

Contract Size: The contract size represents a minimum amount that can be traded. Contract sizes may vary based on the underlying market being traded.

Leverage: This offers the trader the opportunity to control a larger position with a fraction of its actual value.

Long Position: To enter a market by buying, in anticipation of making a profit.

Margin Requirement: A fractional deposit made to the dealer to maintain a market position. With CFDs, you are only required to put up a percentage of the contract value, yet can trade the full amount of the contract. Some markets, for example, only require .5% of the contract value. One note: Trading on margin can create losses as well as gains, so it is very important to identify your risk comfort level before you trade.

Short Position: To enter a market by selling, in anticipation of making a profit.

Spread: The difference between the buying and the selling price of a financial instrument.

** WARNING ** Your investments and any income from CFDs can go down as well as up. You can quickly lose more than your initial deposit. Please make sure you understand the risks. CFDs may not be suitable for everyone.