Contract for Difference Trades for Your Investment Portfolio - dummies

Contract for Difference Trades for Your Investment Portfolio

By David Stevenson

A mainstream alternative to spread bets in the UK is the humble contract for difference (CFD), which is similar to a spread bet in most ways but uses a slightly different structure. A CFD is an agreement between two parties to settle, at the close of the contract, the difference between the opening and closing prices of the contract, multiplied by the number of underlying shares specified in the contract.

In essence, a CFD is a mutant cross between a mainstream options contract and a spread bet. CFDs are traded in a similar way to ordinary shares. The prices quoted by many CFD providers are exactly the same as the underlying market price and you can trade any quantity, just as with an ordinary share.

To trade in a CFD you’re usually charged a commission on the trade, and the total value of the transaction is the number of CFDs you buy or sell multiplied by the market price. But instead of paying the full value of a transaction you only need to pay a percentage of the initial trading position, called the initial margin.

The key point is that this margin allows leverage, so that you can access a larger amount of shares than if buying or selling the shares themselves.

Here’s a straightforward CFD trading example. As with options and spread bets, you have the choice of making a long or short trade.

HSBC shares currently trade at 550–550.5. You think that HSBC will rise in price and so you place a trade to buy 10,000 shares as a CFD at 550.5. The total value of the contract is £55,050 but you need only to make an initial 10 per cent deposit (the initial margin) of £5,505. The commission on the trade is fairly low (around 0.2 per cent of that £5,505) and because you’re buying a CFD, no stamp duty applies.

A week later you discover that your prediction is correct and the share price of HSBC rises to 555–555.5 pence. You decide to close your position by selling 10,000 HSBC CFDs at 555 pence. Your trade makes a 4.5 pence per share profit, which equates to £450 in total.

But to calculate the overall profit you need to take into account commission and financing charges on the deal. Financing charges are usually on a LIBOR plus basis, with interest worked out on a daily basis (note: LIBOR is an interbank lending rate; for non-banks, the rate is higher by a certain number of base points), and so here financing is anything from £5 to £20 depending on interest rates.

Short (bearish) trades work in exactly the same way as long trades, but in the opposite direction, in that you make money when you borrow stock to sell for what you believe is a high price and then buy it back when the price falls.