Contracts for differences: Are CFDs useful?

Contracts for difference - CFDs - have only been available to private investors since the late 1990s, though institutional investors and hedge funds had already been using them for years. They're an interesting form of equities derivative, offering the opportunity for gearing, but unlike options and covered warrants, having no expiry date.

And CFDs now offer more than equity derivatives, as you can also get CFDs on indices and currencies - so you could, for instance, buy the FTSE, or sell the dollar, using CFDs. With a contract for difference, you're making a contract with the CFD provider that you will pay the different between the current value of the asset covered by the CFD, and its value at contract time. The trade is struck between you and the CFD provider - this is a direct contract, not traded on an exchange. If you want to close your position, you simply make a reverse trade.

CFDs are traded on margin, so you get more bang for your buck - you can make a greater profit but equally, of course, you can make a larger loss. Unlike equities, where you cannot lose more than you put in, of course while you're margin trading you can lose vastly more than your original stake. You'll find different brokers give different margin on different CFDs, but generally you'll be putting up between 3% and 15% of the cost of the equity stake as margin.

This isn't free. You'll be paying 0.1% to 0.25% commission - much cheaper than buying the underlying equity. And there's no stamp duty to pay, either, so that's another cost saving. You will, however, pay a financing charge every time you roll the position overnight. You'll also find that if your position starts losing money, the provider is likely to make a margin call - asking you to put more money up to cover the contract. Margin calls must be quickly met or the position can be liquidated.

By the way, if you've bought a CFD on a yield stock like Royal Dutch Shell B or Glaxosmithkline, you'll be happy to know that you are entitled to any dividends paid in the period you hold the CFD.

CFDs work in a way that's not very different from spread betting. However, they lack the tax advantages of spread betting. Because spread betting is seen as gambling, whether it's on football scores or the FTSE, there's no capital gains tax or income tax payable. On the other hand with CFDs, you'll pay CGT on any profits you make.

There is a potential benefit to this tax treatment, though. Because CFDs are liable for CGT, you can offset any losses you make on CFDs against profits you make on your equity portfolio or other investments. You can't do that with spread bets.
CFDs have a number of advantages for the investor.
    •    You can use them to short the market or an individual stock.
    •    They are cheap.
    •    They are offered by many banks and brokers, such as Selftrade and etrade.
    •    Many brokers enable you to place stop loss orders, which minimises your chance of losing more than you invest.
    •    Minimum order sizes are often small.
    •    CFDs enable you to take positions on international stock markets and currencies, as well as UK stocks.

However, the disadvantage is that these are really traders' instruments. You'll need to monitor them consistently, and because of their leveraging and consequent volatility, they're not suitable for a 'buy and hold' strategy. They also become expensive to hold for the long term, because of the financing charge.
CFDs  are most useful to the 'straight' equity investor for a number of special situations.
    •    Where you believe that a definite event, such as a new product launch, will lead to a rerating of a stock in the near future.
    •    Where you want to take a position on a company's results.
    •    Hedging a long position if you're worried about short term reaction to a results statement, or hedging a takeover target against the chance of the bid falling through.
    •    'Bed and breakfasting' could be done tax-efficiently by using CFDs to hold your position, and buying back the shares after the thirty day term.
    •    Hedging your stock without selling it and crystallising a CGT liability. This might be useful coming up to the end of the tax year.

So, just because you don't fancy trading CFDs as a lifestyle, that doesn't mean that they be useful for particular situations. As ever, though, it's important to do your research properly before taking the plunge.