CFD Trading 2013

CFDs or Contracts for Difference,  are legally binding agreements to buy or sell a specified number of shares, or amount of other commodity, the main difference between CFDs and Futures or Spread betting,  is that there’s no expiry date, CFDs can be held indefinitely, they however incur interest rate charge (or credit) on a daily basis since they are a leverage product, and leverage means that you are borrowing (or lending) investing capital.

If for example you wish to buy an amount shares, and hold them for few weeks, expecting to catch an ensuing rally in their price CFDs will usually be better than spread betting, in that a CFD contract will move penny for penny with the underlying stock as its price rises, this is not always the case with futures or spread betting contracts.  That way you are guaranteed to capture the entire price movement, there will be an interest rate charge, depending on the price of the underlying stock, but this is negligibly small compared to the expected gain.  A small stock, of around ₤20 will fluctuate very little in price, both up and down,  and will cost too little in terms of daily interest paid  on a CFD contract held (a CFD to buy that stock),  whereas a high priced stock of around  ₤100 will cost 5 times more in daily interest charges, but will also fluctuate much more up and down, offering the opportunity to profit enormously from these fluctuations. Profit or losses made by the interest rate factor are ALWAYS dwarfed  by the profits or losses made by the price fluctuation factor!

CFDs offer great linearity of price (penny for penny movement) ,  they are exempt from stamp duty, which an issue when trading actual shares on a very high frequency basis, since it’s 1% of the their value!

CFDs  are subject to capital gains tax, that can be a disadvantage compared to spread betting.

CFDs can be used together with other instruments to implement more sophisticated trading strategies, they can be used to hedge a stock portfolio against temporary downside risk, for example, suppose that an investor holds actual 50,000 shares of a stock currently valued at ₤4,  and he believes that there will be a short lived drop down to    ₤3.8 or even  ₤3.5 before the stock starts rising again. Instead of going through the trouble of liquidating his portfolio he can choose to sell an amount of those shares using a CFD contract, that would currently be price at around 404p-396p  this means buying the CFD at 404p or selling it at 396p, if he sells at 396p he can choose a number of shares, which specifies the size of the contract. He can choose 50,000 but because he may be proven wrong and the stock may actually rise instead, he chooses to implement partial hedging by selling short only 30,000 shares at 396p. Whatever happens now throughout the expected turbulent period, regardless if the stock rises, drops, or does both in a volatile sequence,  the investor has limited his downside risk on his long term stock investment,  if the stock does drop to   ₤3.5  (350p), the investor can buy back the CFD realising a profit which will be as follows; 30,000 x (396p-350p) = 30,000 x 0.46 = ₤13,800!

The stock in our example is now at ₤3.5 but because it’s a long term good investment it is strongly expected to rally back up to ₤4, the investor however will have made ₤13,800 out of the temporary drop.

Stocks such as BP, Exxon,  energy and oil stocks, and many real estate stocks are good candidates for long term investing, buying an amount of actual shares, and then hedging against expected downside using CFDs, it can be done using spread betting too, but it may be less accurate. This is because spread betting firms are market makers and have the freedom to move prices slightly away from real underlying markets, and usually this is more evident in far dated spread bet contracts, with CFDs you are much much closer to the real underlying market (share / commodity) and therefore can feel confident to accurately anticipate the expected profit or loss in any given market move.

CFDs can provide excellent profitability to the knowledgeable investor, especially on short term trades and volatile stocks,  they are not recommended on static stocks, stocks that are expected to remain flat in price for long periods.