CFDs: derivatives for more advanced traders

One product similar to spread betting is a contract for difference (CFD). Many professional traders prefer these products to your average spread bet. Here's what CFDs are and why you might find them an investment worth considering.

If you're just starting to trade, spread betting is by far the easiest and cheapest way to get going. But some professional traders prefer another, similar product, known as a contract for difference (CFD). For retail investors these can be worth a look too.

As the name suggests, a CFD is a contract between buyer and seller. And, just like a spread bet, any profit or loss is based on the difference between the price of an asset when the contract is opened and the time it's closed. If this asset, say an ordinary share, rises in price, the buyer receives money from the seller. If it falls, the buyer must pay the seller.

CFDs are also a 'margined' product, meaning you only put up part of the potential total value of the bet. This margin varies depending on which asset you're betting on, but it's typically 10%-30% of the face value of the contract.Like spread bets CFDs are best suited to short-term trades lasting perhaps days or weeks. So far so similar. However, there are some key differences too.

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When you 'go long' ie, buy using a CFD, you have to pay a daily financing charge to keep the position open. This finance charge represents interest on the money you're borrowing from your CFD provider because you're only putting up margin, not the full price of the asset. Over time, this can mount up and eat into your return. Note that if you go 'short' by selling a CFD, you will receive a financing payment (at a lower rate than you'd be charged on a purchase). However, you'll also suffer a borrowing charge that reflects what it costs for your provider to obtain the stock for you to short. This shouldn't put you off as the costs of a spread bet and a CFD are often pretty similar.

Offsetting your losses against tax

So why choose CFDs over spread betting? The most obvious reason is tax. Spread bets are exempt from capital gains tax, since they are classed as gambling. Gains from CFDs are not. For most investors, this sounds like a disadvantage. And it is unless you have a strange compulsion to pay more tax than you need to. But the other side of the coin is that spread-betting losses aren't deductable against tax, while CFD losses are. For someone with a mixed bag of profitable and loss-making trades, the ability to claim loss relief may come in useful. For example, if you are using 'short' trades to hedge a long-term investment portfolio, you can neutralise the overall tax position more easily.

There are a couple of other differences, too. For example, unlike spread betting, a CFD usually carries dividend entitlement. That means the seller of a share owes the buyer an amount equal to any dividends that are paid by that share during the life of the contract. This could be useful for trades involving high-yielding stocks or those paying special dividends. And the bid-offer dealing spreads on CFDs may well be more competitive than those offered by most spread-betting firms, making CFDs more attractive for high-volume traders. Check this with your spread-betting/CFD provider.

Listed CFDs

Perhaps the biggest hurdle you'll meet with many CFDs is the need to set up a specialised dealing account. This typically has a reasonably large minimum funding requirement. So listed CFDs, otherwise known as Turbos, could be a way to dip your toe in the water.

A listed CFD is a hybrid product half way between a CFD and a covered warrant. As the name suggests, they are listed on a stock exchange and can be bought through your broker with a normal share-dealing account. They have a fixed lifespan and a built-in stop-loss, with the maximum you have at risk being the initial amount you pay for the contract. And they come with the full tax deductibility of a normal CFD.

Sounds useful. Unfortunately, there are a couple of snags. First, Turbos have a feature called a 'knockout barrier'. If the price of the underlying asset drops below this level at any point, the listed CFD expires worthless.

To understand how this works, think of a listed CFD going 'long' the FTSE 100. It has a strike price and a knockout set at 5,400. With the FTSE at 5,700, the CFD trades at say 35p. The FTSE then rises to 5,750, a rise of 1%. The price of the CFD might go up to say 40p, a gain of 15% on your initial stake. This is around the same return you'd expect through a spread bet or a normal CFD, and a bit more than you'd get by using an option or covered warrant for the same trade.

But if the FTSE were to drop below 5,400, the CFD would expire and you'd get nothing, even if the index then recovered. The same would also apply with a stop-loss on a spread bet or normal CFD. But with the latter you can choose where to place your stop-loss and even move it around. With a Turbo, it's fixed. Also an option or covered warrant would be back 'in the money' if the index were to rise above the strike price again.

The other problem is that the range of listed CFDs is small. Socit Gnrale was the main provider for several years. However, even SocGen has reduced its offering of Turbos recently: the current line up of contracts is down to three index-based and four currency CFDs. On the plus side, pricing seems to have become more competitive and longer-dated contracts have been introduced.

So if you want to try CFD-style contracts without a CFD account, this is the way to do it.

For many novices, though, the spread bet remains the best way into derivatives trading for the time being.