CFDs explained

For experienced, frequent traders in financial markets, contracts for difference (CFDs) are an increasingly popular alternative to spread betting. Indeed, in the first quarter of 2009, CFD volumes were up 12% on the same period last year, according to Compeer analysis, as investors went 'short' i.e. they bet share prices would fall.

What is a CFD?

CFDs are similar to spread betting in that you can bet on stock price movements without having to actually own the shares. The key difference is that spread betting is considered a form of gambling, so is free from capital gains tax and stamp duty, but CFDs are only free from stamp duty. But either can be closed out at any time.

How does a CFD work?

Say you believe that a particular stock is going to rise in price from its current level of £100. You decide to invest £1,000 by buying 10 shares. If the share price rises to £120, excluding dealing charges, your profit is £200 (£120 - £100 x10).

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However, with CFDs, you could make a much larger profit by gearing up. This is because the CFD provider usually requires you to invest only an initial 'margin', normally between 10% and 20% of the value of the underlying shares. If your margin is 20%, your £1,000 would let you buy £5,000-worth, or 50, of the same shares. So if the price rises to 120p, your profit is £1,000 (£120 - £100 x 50).

Clearly, though, your risk of losing money with CFDs is much higher than buying the underlying shares. Think of it like a purchasing a house with a mortgage. If you were to buy for £400,000, and you could put down a deposit of £80,000, you'd need to borrow the other £320,000. If the value of the house rises by 10% to £440,000, the value of your equity goes up by 50% (£440,000 - £320,000 = £120,000 / £80,000). But if the house price drops by 10% to £360,000, you lose half your deposit (£400,000 - £360,000 = £40,000/£80,000).

What are the advantages of CFDs?

You don't pay any stamp duty, unlike share purchases. And during the life of the CFD, you are entitled to any dividends paid or stock splits issued by the company whose shares you're buying.

Further, you can trade in many stock market indices, such as the FTSE 100, as well as a range of currency exchange rates. Currently CFDs aren't allowed in the US due to Securities and Exchange Commission (SEC - the US regulator) rules.

But CFDs aren't particularly cheap to deal in you pay 0.1% of the contract face value on both sides of the trade. Some brokers use real prices with no hidden charges added to the bid/offer spread, and fees are levied separately. Others claim to offer commission-free trades, but the dealing costs are usually factored into the spread.