CFDs explained

Have you ever had a hunch that the price of oil is going to keep rising, or the pound will fall further, and been prepared to back it with your own money?

If so, you may be interested in contracts for differences (CFDs): securities that allow a large investment to be controlled from a small deposit. They are derivatives, in that their own value is based on the underlying value of another security.

Though they are best known as methods for betting on short-term market direction, up or down, CFDs can also be used to take a position over months or years, which is made easier by their lack of an expiry date. They also offer an excellent way for conventional investors to hedge existing positions. They dovetail extremely well with the ownership of stocks, shares, funds and other investments because of their tax treatment, which we'll discuss later.

Wide range of markets covered
There is such a range of markets now covered in CFDs that you can back almost any view. If you believe that the oil price is set to go higher again, you could back that view by taking a long CFD position in Brent Crude. If you believe that the euro will collapse in three months, you could 'short' the currency over the same period. Likewise, if you believe that BP will finish the day higher, you can back that too.

CFDs use the idea of leverage to magnify gains and losses compared to the movement in the underlying security. That is true whether an investor is going short or long. The investor deposits a proportion of the value of a deal and the broker loans the rest. Though you pay interest on your loan, you also gain the dividends or other income on long positions or receive interest income on short positions.

High-risk products and not for beginners
It's important to realise from the outset that it is the loan element which means that you can easily lose more than your initial investment. In their raw form, CFDs are high-risk products, though there are many ways to manage or diminish that risk.

Still, we are not shy about leverage. Its effect on magnifying gains and losses is familiar to us in house purchase. A couple buying a home for £200,000 may put down a 20% deposit (£40,000) and get a mortgage for £160,000. If the house value rises by 10% to £220,000, the value of their equity in it has jumped by 50% to £60,000. Or, if house prices fall by 10%, the house is worth only £180,000 and the equity is halved to £20,000. That is exactly how leverage in a CFD works too.

The technicalities soon become familiar. Whether you go short or long, you put up anything from 1% of the deal, in the case of a widely traded index, to 10-15% for an obscure security, which is your margin deposit. Margin is calculated daily for the most popular securities and you pay interest on the size of the deal. The uncommitted money you have left in your account, your free equity, is adjusted by your overall profit or loss.

The advantages and temptations of leverage
It is the sheer temptation of leverage that is the main danger for those inexperienced in CFDs. Using anything like your full margin can result in margin calls (a demand for extra money to top up your account) if prices move against you. If you cannot quickly access extra cash your position may well be closed for you. CFDs therefore carry a high risk to your base capital.

With deposits sometimes below 1%, and markets that can move several per cent in a day, it is clear that it is possible to make losses which vastly outweigh your deposit. This risk can be offset by using one of a number of stop-loss arrangements that brokerages offer, which will effectively pull you out of a losing position before any serious money is lost. For peace of mind (and to avoid having to constantly monitor positions), stop losses - most of which are free - are well worth using.

Simplified CFD position
Here's how a simplified CFD long position might work, ignoring interest and any commission:

An investor sees the FTSE 100 at 5,900 and believes it has further to rise.

The CFD broker's quote is 5,899-5,901
Buy to open at 5,901
The investor commits to one contract
Value of investment (£1 x index value): £5,901
Margin of 1%: £59.01

A week later the index has risen to 6,000
The CFD broker's quote is 5,999-6,001
Sell to close at 5,999
Value of investment: £5,999
Trading profit (£5,999 minus £5,901): £98
Profit margin on funds deposited (£98 ÷ £59): 66%

Comparisons between CFDs and spread betting

It is important to note that when you short a share or bond you have to fund any dividends or coupons due during your period of ownership, and your position will be adjusted to take account of this.

Hedging and CFDs
CFDs are an ideal tool for hedging because they receive the same tax treatment as most of the investments against which they might be hedged. For example, if you hold a FTSE 100 unit trust, but worry that the index may fall substantially in the next few months, it is possible to hedge this by taking a short position on the index.

This means that any losses in the value of the unit trust are fully offset by profits in the CFD from the moment when the hedge was set up. When the positions are closed, likewise, any capital losses on the unit trust can be offset against gains on the CFD, or vice versa.

This is not possible with spread betting because the investment is constructed as a wager. That means that any profits are not taxable, but losses are not allowable, and thus cannot be offset against profits elsewhere. It should be pointed out that tax rules do change, and individuals should check not just the latest rules but their own tax situation.

CFDs are available through a variety of specialist brokers.

Sensible precautions for leveraged trade
Beginners in CFD trading would be wise to try their hand doing several weeks of 'paper' trading, or using a demonstration account, before committing any real money. Many active traders find that a working knowledge of chart analysis is essential to effective trading too.

Finally, though there are always tales of those who have made their fortune in such products, it is best to keep objectives realistic, as well as accounting for the considerable time required to monitor fast-moving markets. For every winner, there is always someone else less fortunate on the other side of the deal.