What Is CFD Trading?

The simplest definition of a CFD, or a contract for difference, is an agreement between two parties to exchange the difference between the opening and closing price of a contract for a financial instrument. Considered derivatives because they derive their value from the performance of the underlying asset, CFDs are also leveraged products that let you maximise your exposure to the market for a fraction of the price you would normally pay to own and trade the asset directly.

Often used for speculative trades, investors can profit by either taking long positions when they believe the price of the underlying asset will rise or short positions when they believe its price will fall. Depending on the CFD provider, contract prices may be offered for currencies, commodities, indices, shares, and other trading vehicles.

Key features of CFD trading

A relatively new trading option, CFDs were introduced in London in the early 1990s as a type of equity swap that could be traded on margin. Because they required only a small investment to hedge large exposures to financial markets, CFDs became a favourite of hedge funds and institutional traders alike. The real growth in the use of CFDs, however, was made possible by retail traders on the internet. What makes them different from other trading instruments? Let us take a moment to explain.

High leverage

The principal selling point of CFDs is that they provide significantly higher leverage than traditional investment vehicles. Although rates do vary, margin requirements as low as 2 percent are considered standard in the industry. In other words, you could go short or long £1000 of British Petroleum (BP) shares with a paltry £10 deposit. The fact that initial investment requirements are so low makes CFD an attractive option for individual traders. But high leverage trades can also be quite risky, since losses are magnified just like gains. It is in fact possible to lose more than your initial outlay if the difference between the opening and closing price of the contract is greater than your investment.

Profit in any market

Unlike a traditional investments where you only benefit when prices rise, CDFs give investors the ability to go long (buy) or go short (sell) in various instruments, which allows them to earn (or lose) money whether the markets are rising or falling. This flexible financial tool is a great boon to active traders who never want to sit around on the sidelines waiting for the markets to go their way.

Inexpensive hedge

If you fear that your physical portfolio may lose value, you can purchase CFDs to offset any potential losses with short selling. Let’s say, for example, that you have £10,000 of British Petroleum (BP) shares in your portfolio. To protect that investment, you can inexpensively short sell the same value of BP shares with a CFD trade. Should the shares then fall in market trading, the loss would be recovered by the gain in the CFD short sell trade. Many ordinary investors now use CFDs to protect their portfolios from substantial losses, especially when market volatility rises.

Tax efficient*

Like many other investments, it may be possible to use the loses you incur trading CFDs to reduce your total Capital Gains Tax (CGT) liabilities. As you might expect, the size of any deduction will depend on your individual tax circumstances and how much you lost on trades in that tax year.

Variety of trading options

Because CFD trading encompasses a wide range of financial instruments, including currency, shares, and commodities, there is almost always a market open somewhere where contracts can be traded. Many online investors actually trade at night, long after the London Stock Exchange has closed for the day.

Free from stamp duty*

Because they are financial derivatives that do not require you to own the underlying asset, traders can save 0.5% on the value of each CFD trade that would normally be charged as a stamp duty. It is important to note that there are some exceptions to this general rule. In the UK, for example, there is no stamp duty on any CDF trade, with the lone exception of Irish shares, which are currently charged at 1 percent of their trade value.

Global marketplace

CFDs are traded in thousands of financial markets around the world; not to mention the fact that contracts can be created for a multitude of financial instruments. New investors can go long or short in contracts for currencies, interest rates, sectors, shares, commodities, and much, much more. From Europe to Asia, Australia and the UK, contracts are traded all over the world at most hours of the day and night.

*Tax laws are subject to change and rates are based on individual tax circumstances.