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).

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.

When it comes to taking a punt on the direction of shares, both spread bets and contracts for difference(CFDs) are possible choices. Both allow you to place up ('long') and down ('short') bets, both are liquid (so opening and closing a position is straightforward), both are margined (so you get lots of bang for your buck) and both are offered by a number of firms so costs are generally low. However, when it comes to hedging, CFDs have one big edge tax.

At first glance, this might seem odd. Surely spread bets are better since they don't attract capital gains tax? Well, for a gambler that's a big plus for sure. Why hand over 18% or 28% of your profits (depending on what rate of tax you pay for income tax purposes) if you don't need to? However, for a hedger someone seeking to protect, say, shares against a price fall the tax treatment of CFDs can be a winner.

The reason is that while, yes, you will be taxed on any gain on a CFD much as though you had bought shares, you also get the benefit of tax losses. What that means is, say you sell a CFD as a hedge against some shares you own and don't want to sell just yet. The shares then rise, rather than fall as you expected. The CFD will lose money you will buy it back to close out the position for more than you sold the contract for. But you'll be able to offset the loss against any gain realised on the sale of shares. So, say you sell shares for a gain of £1,000 but lose £800 on a hedging CFD contract. Your overall gain for CGT purposes is £200, not £1,000 as it would be had you hedged using a spread bet with no tax relief for losses.

Better still, since CFD prices tend to track the underlying share closer than spread bets, your hedge using CFDs will probably be more precise. So, much as though we like spread bets, CFDs undoubtedly have their uses. Hedging is one of them.

Sooner or later most spread betters will come across a similar product the contract for difference, or CFD and wonder whether they'd be better off using it. After all according to Investment Trends, quoted in City AM "62% of CFD traders claim gains in the last twelve months". For spread betting the equivalent figure is just 50%. So should you switch to CFDs?

At first glance there's little difference. Like a spread bet a CFD lets you go long or short (bet on rising and falling prices). It's also margined so a small deposit gets you a lot of exposure to an underlying asset. However a closer look reveals some differences too.

The big one is tax CFD profits are taxable whereas spread betting gains are not. That might seem like a big drawback but there's a flipside losses on CFD trades attract tax relief whereas spread betting losses don't. Then there are charges spread betting providers take their cut via the bid to offer spread. CFD providers on the other hand also levy a spread but charge a financing cost on top. In short a long CFD is in effect like borrowing an asset in order to bet that it will rise in price. Your broker the lender will expect to earn money for lending you the asset.

So which is best? For novices we still prefer spread bets. The charging structure is simpler as is the tax treatment. And in the forex market in particular they are still preferred by most traders for being the cheaper option. As for those extra profits claimed by CFD traders, as Ian O'Sullivan of Spread Co puts it "CFD traders tend to be an older, more mature, more long-term type of trader". Tellingly he also notes something I regularly warn about too they have more patience "giving themselves a chance of turning a profit". So rather than change products if you are losing money regularly, try changing the way you think instead.

Contracts for difference are very similar to spread bets in many ways. However we'd normally only recommend them for professional traders.

Like a spread bet, a CFD allows you to place 'up' and 'down' bets on a range of assets, from shares to currencies and commodities. An 'up' bet involves buying a contract, hoping the price rises in line with the underlying asset and then closing the bet by selling the same contract for a higher price.

'Down' bets work in reverse, with the opening trade being a sale of a CFD to create a 'short' position. The advantages of using CFDs over, say, betting by trading the underlying asset are similar to those of spread bets it's quicker and usually cheaper to trade a CFD, and you don't get stuck holding the underlying asset.

Like spread bets, CFDs are margined products you only put down a percentage of the value of the contract up front typically between 5% and 20%, depending on the riskiness of the bet.

Claim your FREE report from MoneyWeek: An introduction to online trading, with tips & advice including:

• Spread betting The easy way to geared, tax-free returns
• Forex trading- How to profit from currency movements

So what's not to like? Well CFDs differ from spread bets in one crucial respect tax. Whilst a spread bet offers tax-free gains, a CFD does not. You pay capital gains tax on profits and can use losses to reduce future CGT bills too. Next, you usually suffer a daily financing charge to run a CFD position. Keep it open for, say, a couple of months and this can add up. So, as a rule of thumb we would only recommend CFDs over spread bets for day traders and institutions such as hedge funds.