What you need to know about 'contracts for differences'
Contracts for Differences (CFDs) provide an exciting way of benefiting from movement in the stock market without actually purchasing any shares. They involve forming an agreement with a broker and committing to exchange the difference in value of specified shares between the opening and closing of a CFD. The contract amount on closing is dependent on the number of shares included and the rise or fall in share price.
The popularity of CFDs is based on two distinguishing characteristics. The first being that CFDs can be used to predict decreases in share value as well as share increases. The second is that CFDs are based on margin trading.
If an investor buys a CFD based on the prediction that the value of this stock will rise it is known as 'going long'. However, unlike traditional investments in the stock market you are able to use a CFD to benefit from a predicted decrease in stock value. This is known as 'going short' and involves the theoretical sale of shares that you don't actually own with the hope that the stocks value will decrease and you will be able to buy them back at a reduced price. This feature makes CFDs a more versatile form of growing your investment especially as it is possible to use them to hedge against the decrease in value of shares you actually own.
CFDs are based on margin trading which means that unlike traditional investments, you only have to deposit a percentage of the value of the contract (usually 10%), although you must be able to demonstrate to the broker that you have the funds in place to cover the rest of the contract, should the share movement go against your prediction. As you haven't had to put down the whole contract amount you are able to take a bolder position, potentially resulting in a far greater growth in capital compared to your initial deposit.
Although the benefits of your investment can be multiplied using CFDs if your prediction relating to the movement of share prices is correct, this multiplication is also applicable to any potential losses. Due to the nature of CFDs your capital is not secure and it is a very real possibility that you will lose more than you entered into the contract with and so are a high risk form of investment only suitable for experienced investors.
There are mechanisms such as stop loss orders which can be put in place to minimise the risk of a huge loss; these act to automatically end the contract if it moves below a specified loss making position. There is often a charge imposed by the broker if a stop loss order is included in the contract.
There are likely to be other charges associated with investing in CFDs, for instance you are likely to be charged an arrangement fee by your broker. Additionally, if you hold a CFD overnight you are likely to be charged interest; for this reason CFDs tend to be more suitable as a very short term investment. You will also be liable to pay capital gains tax on your profits, however unlike regular shares you do not have to pay stamp duty on your transactions.
As CFDs use margin trading, enable you to profit from highs and lows in the stock market and give you access to a wide range of investment opportunities, they can make for fantastic profits. However, they can also result in large losses so you should only ever consider entering a CFD if you have other secure financial provisions in place, have money available to fulfil the rest of the contract if the share value moves in the opposite direction to your prediction and fully understand the implications and risks associated.
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