A contract for difference (CFD) is an agreement between two parties to trade the difference between the opening price and the closing price of a contract, multiplied by the number of shares as calculated at the end of the contract.
CFDs can be bought and sold on the top 350 stocks in the UK, as well as some stocks in continental Europe and the US. If you invest in a CFD, you won't be the registered owner of the underlying share. This means you won't be able to vote on issues or get discounts on products. But you are entitled to payments called dividends.
You can trade CFDs online or over the phone, but you'll need at least GBP10,000 to get started. CFDs are good for investors who know what they are doing. Brokers in the UK won't do business with you unless they know you understand the big risks.
CFDs are very geared, just like spread bets. You will buy on margin, which means you will put up 10% to 25% of your total investment and borrow the rest from your broker. At first, you will have to pay market-to-market margin calls with cash that you put down in advance.
The broker will take a cut of the spread or charge a commission on CFD trades. The company will also charge you interest on the money you borrow to buy something (taking a long position). On the other hand, it pays interest once you have sold a position short (for which CFDs, like spread bets, are ideal).
In either case, the interest rate is usually a little bit more than the base rate, and it is recalculated every day. You won't have to pay stamp duty when you buy a CFD, but you will have to pay capital gains tax on any money you make. You can keep your open position in CFDs for as long as you want, as long as you pay margin calls and interest on loans. But they are usually only good for short-term trading.
Common trading strategies: You can use CFDs to your advantage when you want to make a quick profit or to protect yourself from loss. Let me give you two examples of this kind of trading.
The first is to buy contracts for difference (CFDs) on stocks that are likely to be added to the FTSE 100 index when its components are reviewed every three months. At this point, companies with a market capitalization lower than 110 are kicked off the index and new ones are added.
If you want to use this strategy, you should buy the relevant CFD a few days before the official announcement of the new index members. You should sell the CFD the night before the stock is added to the FTSE because the share price usually goes down at this time. You could also sell short stocks that are likely to drop out of the FTSE 100 index and then buy them back. Visit the FTSE site to keep up with changes to the FTSE 100 index (www.ftse.com).
The second method is called dual trading or spread trading. This is when you bet on how well one stock will do against how well another stock will do. You can buy a CFD on a stock that you think will do well and sell short a stock that you think is too expensive. Traders often pick two stocks from the same industry that have reacted in the past to the same news and problems in the industry. Using this strategy, you will keep a pretty neutral position in the market.
You'll get more money if the stock you backed for outperformance goes up in price, and you'll have less risk if it goes down.
Choosing the right broker: When looking for a broker or bookmaker, look for fast execution of deals, low prices, and access to high-quality research.
Competition for CFDs: The London International Financial Futures Exchange (LIFFE) started selling universal future contracts (UFCs) in early 2001. It started with 25 large companies from Europe and the US. Now, there are 115, including France Telecom, Deutsche Bank, and Microsoft.
UFCs are similar to CFDs, but they are less flexible and may be cheaper to deal with. Through the London International Financial Futures and Options Exchange (LIFFE), they are regulated and offer a simple, low-cost way to invest in international stocks.
Even so, UFCs are more interesting to institutional investors than to private investors right now, but this is likely to change. Visit the LIFFE website to find out more (www.liffe.co.uk).
