What is a Contract for Difference?
A Contract for Difference (CFD) is an agreement between two parties to settle the difference in value of the share between the open and close of the contract, where the seller will pay the buyer the positive difference between the current and future values and the buyer will pay the seller the negative difference. There is no need for the underlying shares to be owned by the investor for a position to be taken and there is the possibility to take either long or short positions. CFDs are traded on margin and as a result the investor is asked to put down a margin of between 1% and 30% of the notional value of the CFD. This allows the investor to put a larger sum of money into the investment than if he was to actually buy the stock and hence the potential to make large sums of money is exaggerated. However if the share travels in the wrong direction the broker will ask for the margin to be topped up with cash and hence there is also a large chance that the more money will be lost than initially invested. CFDs can be either exchange traded or Over The Counter (OTC) transactions and at present are free from UK stamp duty but are subject to CGT.
Top Tips:
- Be aware that holding a CFD will entail an interest charge usually at or around LIBOR (London Interbank Offered Rate) meaning that holding the CFD will cost you more money the longer you hold onto it.
- Commission charges are low and should be no more than 0.25% of any trade.
- Commissions could be eliminated by using a market maker who should make commissions through the spread.
- Use Stop Orders to minimise any losses and thereby lower the risk of these derivative investments.
- This area is only for experienced investors. Although the potential profits are tempting the potential for loss is just as severe. Novice investors should look elsewhere.
