A perennial favourite of investment professionals, contracts for difference (CFDs) also make a big splash with private investors looking for a simple, cost-efficient way to play the markets. In essence, a CFD is an agreement between two parties to exchange the difference in the current value of an asset and its value at a given point in the future - if the difference is positive, the seller pays the buyer, but if it is negative the buyer loses money.

In common with fellow leveraged tool the spreadbet, CFDs are free of stamp duty, allow trading on margin to give investors more bang for their buck, offer the flexibility to go long or short and provide easy access to a broad range of asset classes, from equities and commodities to currencies and indices. And while these features alone might be enough to make them a hit, CFDs also come hard-wired with distinctive characteristics that mark them out from other trading and investment products.

Made to fit

Chief among these is their simplicity and correlation with the market they track. CFDs mirror the performance of an underlying market and are priced in the same way. Better still, the cost per trade is much lower compared with buying and selling ‘real’ assets and the requirements are more straightforward - put simply, they save the investor a good deal of hassle. ‘As CFDs are priced to reflect the value of the underlying instrument, they provide a synthetic way of getting the same exposure,’ confirms Aditya Laroia, deputy head of CFD and listed products at Saxo Bank. ‘As such, they are generally used by investors looking for efficiencies in their processes and who want to use a transparent and packaged solution.’

‘The big advantage of CFDs is they allow investors to trade a wide range of assets with high frequency without incurring hefty fees,’ explains Lior Alkalay, senior research analyst at eToro. ‘There is much uncertainty in the current financial environment and investors have to be flexible and react quickly. This is where CFDs come in - their relatively low fee structure and correlation with the underlying can help investors navigate difficult market conditions and preserve returns.’

One asset class that neatly demonstrates this instrument’s special blend of leverage, flexibility and like-for-like contract sizing is equities, where a CFD contract will work just like buying shares from a broker. For example, an investor would buy 1,000 Vodafone (VOD) CFDs, just as he or she would pick up 1,000 Vodafone shares from a broker. ‘CFDs are very simple for anyone used to traditional sharedealing,’ confirms Christopher Beauchamp, market analyst at IG. ‘It’s easy [with a CFD] for an investor to specify what share or other market to buy, and what contract size they would like. Many people find this easier than buying or selling pounds per point - as is the case with spreadbetting - and with CFDs there’s is no rolling over, as you can take out a contract and sit on it until you close it out.’

‘The like-for-like contract sizing is one of the reasons CFDs are regularly used by share dealers,’ agrees Josh Raymond, chief market strategist at City Index, which bagged this year’s Shares Award for Best CFD Provider (see this week’s special inbound supplement). ‘And it is definitely easier for regular share dealers to correlate positions to equity CFDs.’

Flexible friends

A further benefit of CFDs is their flexibility to go long or short, coupled with their scope to access a vast range of markets. This makes them useful tools for managing risk in an investment portfolio. CFDs are particularly well suited to hedging in cases where an investor wishes to retain a core shareholding - for example as part of a long-term growth strategy - but may be concerned about temporary price weakness.

‘If the investor feels that a stock held in his portfolio is heading
lower, this risk can be hedged by selling an equivalent number of CFDs of the stock,’ explains Fawad Razaqzada, technical analyst at GFT Markets. ‘The investor will benefit through the short CFD position if the price falls without liquidating his long position in the underlying stock, and will also save on transaction costs that come with sharedealing, such as stamp duty. Such a strategy could have played out recently by taking out a short CFD in Apple (AAPL:NDQ) to offset the roughly 25% correction that took place over six weeks or so this autumn.’

‘CFDs are certainly a useful way to offset risk,’ confirms IG’s Beauchamp. ‘For example, Severn Trent (SVT) showed some share price weakness recently, and investors holding the utility could have used a short CFD to hedge their position’ (see ‘Hedge your bets’ page 48).

Another factor in the mix here is the particular tax implications of CFDs, as City’s Raymond explains: ‘Because they are subject to CGT (capital gains tax), CFDs can be used to hedge against a potential loss in the value of an investor’s share portfolio while also offsetting any losses in CGT liability.’

Buy and hold

Beyond hedging - where a short CFD is used to avoid liquidating a physical share - the instrument itself can also be held for a longer time frame, either to create fresh exposure to a market or ramp-up gains on an existing holding (see ‘The long game...’, right). As CFDs are traded on margin, in cases where an investor is long there will be a daily financing charge applied to their account, while short positions will receive interest. ‘CFDs can be used by long-term players as part of a buy-and-hold strategy, but there are things to consider,’ counsels GFT’s Razaqzada. ‘The first is the financing charge, which is the interest on the amount that you are effectively borrowing in your margin account - although it is not huge, the costs will add up over the long-term. Another consideration is that if the position goes significantly against you there could be a margin call.’

‘A CFD can be used by investors taking a short-, medium- or long-term view,’ agrees Saxo’s Laroia, who also flags the financing implications of pursuing a buy-and-hold strategy. ‘When looking at the longer-term horizon using CFDs, it is important to consider the funding situation. As CFDs are traded on margin, there are financing costs to borrow the remaining value of the investment - however, these rates are typically very competitive when compared with other options available to the investor community.’

Access all areas

As much they may suit a buy-and-hold strategy, equities are not the only game in town. CFDs can be used to trade a plethora of asset classes and the product scores well here by providing efficient leveraged exposure to markets that can be complex or otherwise difficult to trade. Smaller CFD contract sizes are especially helpful for giving regular investors easy access to commodities such as oil, where contract sizes in the underlying futures market are far larger. For example, on some CFD platforms the minimum commodity CFD lot size for US crude oil can be as little as 25 CFD contracts (equivalent to 25 barrels of underlying), which compares with a typical minimum trading size of 1,000 barrels on the futures market. What’s more there is no physical delivery with a CFD, so investors need not worry about barrels of the black stuff being unceremoniously dumped on their well-manicured suburban lawns.

‘A clear attraction of CFDs is they provide exposure to a broad range of markets - including global equities - that may not be available from a traditional share broker,’ says IG’s Beauchamp. ‘They also simplify trading on markets that can otherwise be daunting, such as commodities, as there are no worries regarding futures and delivery. Contract sizes can [be adjusted to] help manage risk, and traders can easily reduce or add to their positions as required.’

‘CFDs are especially useful when it comes to trading commodities,’ confirms eToro’s Alkalay. ‘Opening a position on an oil future requires substantial margin to be deposited, which is a problem for most retail traders. Also, oil is a 24-hour market and while some investors use ETFs to track commodities these are not round-the-clock trading instruments - so if you have to wait for the NYSE ARCA market to open, for example, you might miss an opportunity and your ETF may gap on open. CFDs fluctuate 24 hours a day in tandem with futures and trade in small units, and this combination provides the ultimate solution for retail traders who want commodities exposure.’

Saxo’s Laroia highlights the ‘access all areas’ pass provided by CFDs, which provides a route to a range of interesting markets, including fixed income. ‘CFDs are able to wrap almost any asset class, and Saxo Bank offers CFDs on equities, futures, indices, bonds, currencies, ETC/ETFs and commodities,’ says Laroia. ‘In products such as fixed income - where the market is predominantly “over the counter”, with limited transparency and often high barriers to entry - CFDs offer a simplified option with leveraged financing.’ S

The long game:
A buy-and-hold CFD sample trade

Encouraged by strong first-quarter results at retail and leisure group Whitbread (WTB) (19 Jun), an investor thinks the company’s share price will rise. He decides to take out a long CFD the next day for leveraged upside rather than add to his shareholding, setting up the trade as follows:

Asset class: Equities

Market: Whitbread

Instrument: Long CFD

Time frame: Six months aprox. (159 days)

Trade: Buy 1,000 Whitbread CFDs

Opening level (date): £20.59 (19 Jun)

Stop loss: £16.47

Contract value: £20,590

Outlay (based on 10% margin): £2,059

Closing level (date): £23.46 (26 Nov)

Change: +287p

Gain on CFD trade: 287 x 1,000 = £2,870

Return: 13.9%

Financing costs: 4% x £20,590 = £823.60/365 = £2.26 x 159 = £359.34*

Commission costs (charged at 0.1%): £20.59

Total trading costs: £359.34 + £20.59 = £379.93

Net profit on trade: £2,870 - £379.93 = £2,490.07

Overall return: 120.9%

Source: Shares

Notes:

* Long CFDs incur a financing charge of Libor plus 2.5% to 3.0%, giving a levy of 4.0% per annum charged daily - in this case at £2.26 over 159 days, the duration of the trade.

This calculation does not include any dividend adjustments.

CFDs are subject to capital gains tax; always take individual tax advice.