Contracts For Difference and why they can be Superior to Share Dealing

The Contract For Difference, or CFD, has seen massive growth over the last 10-15 years as investors have gained awareness to the many benefits it has over traditional share dealing.  This article will highlight these advantages but we will begin by looking at what a CFD actually is.

What is a Contract For Difference?

A CFDs is a method of financial trading that has many similarities to spread betting and is a service that is increasingly being offered by spread betting companies.  The contract is normally agreed between two parties: the private investor and the CFD broker.  It states that these parties will settle the contract at some point in the future with one paying the other the difference between the opening and closing prices of an underlying asset.  Most financial markets are tradable with CFDs including shares, forex, commodities, entire indices and many more.

An example of a CFD

Company ABC is currently trading at £5 a share and Investor M expects this share price to increase.  Investor M therefore buys a contract with a value of £5000 (an equivalent holding of 1000 shares) but because CFDs are traded on margin, they are only required to put down the margin requirement of £500.  If the share price doubles over a six month period, M will have made a £5000 profit.  If the price falls by 50%, M will be liable for a £2500 loss.  In the event that the price does in fact drop, Investor M will be required to have funded his account to cover the margin requirement otherwise the broker will have stopped the position out before.

The above example is simplified and does not factor in financing charges or the initial spread that the CFD broker will charge. 

CFDs are tradable from many countries in the world although they are particularly popular in the UK (where they were invented), Ireland and Australia.

Advantages over Share Dealing

Although Share dealing is a very straight forward way for your average investor to speculate on share prices, it is also a very limited solution.  Contracts For Differences can serve the same purpose but also come with the following advantages:

Market Variety

Stock brokers tend to only offer access to company shares.  CFD brokers however allow their clients to trade on a huge variety of markets.  IG, for example, offer in excess of 10,000 different markets including shares, entire indices, soft commodities, energy, precious metals and interest rates.  This huge amount of choice allows for a much more entertaining investment environment.

Shorting

If you are new to investing then you may have heard of the dreaded ‘shorter’.  Someone who is ‘short’ on a stock basically holds a position where they are betting on the share price going down.  You too can take such a position when trading using CFDs which is a great tool to have in your armoury during bear markets.  You will often find sustained periods of market decline which is a prime opportunity to make money by going ‘short’.

Leverage

As mentioned in our example, CFDs are traded on leverage meaning you can open positions worth far more than the cash balance of your account.  By being able to open positions of such size, it is possible to make superior gains to what you could when dealing with a stock broker.  Of course it is important to bear in mind that losses can also be far greater.

Risk Management

Most CFD brokers offer told such as the stop loss and limit order.  The stop loss is required by any one that wants to be successful in trading and is an order you can setup to automatically close a contract, if the price hits a level you are uncomfortable with.  It enables you the peace of mind that losses won’t exceed a predetermined level that you have set.

Summary

As we have seen, CFDs can be an excellent tool for investors to use.  They can serve the same purpose as stock broker but come with a variety of benefits including the ability to trade on margin (leverage) and being able to speculate on falling prices.  They are also considered by many to be a more enjoyable way to trade due to the sheer number of tradable markets available with CFD brokers.