Contracts for Difference (CFDs)


CFDs have grown in popularity for experienced investors as an attractive means of gaining exposure to individual equities without the need to own the stock and at approximately only a tenth of the cost of actually buying the stock.

A CFD is a traded financial instrument linked to the underlying share price of the stock in question. No rights are acquired or obligations incurred in buying a CFD relating to the underlying stock. Depending on your view of a company’s prospects you may choose to buy (go long) or sell (go short).

The ability to profit from falling share price, ie to go short, is one of the principal attractions of CFDs as other methods of going short are both expensive and inconvenient.



Key Features of CFDs


CFDs are geared or leveraged instruments. This means that a deposit of only around 10% of the value of the stock and CFD is required. Conversely, it is possible to hold a position 10 times greater than would be possible with a traditional investment.

This degree of gearing offers opportunity for greater profit for a correctly anticipated share price movement. On the other hand, the risk of loss increases commensurately if the anticipated shares price moves against you.

In the case of substantial and adverse market movements the potential exists to lose all of the money originally deposited and to remain liable to pay additional funds immediately to maintain the margin requirement.

CFDs are available on the stocks or shares of companies comprising the FTSE 350, in the UK, the S & P 500, Dow Jones and Nasdaq 100 in the USA and most of the major continental European companies.

The counterparty to the holder of a long CFD position will have had to borrow the stock in the market and in order to fully mirror the economics of physical purchase interest will charged. The margin deposit is held to secure the performance of the contract and is not available to be set-off against the Contract Value.

As a consquence, a long CFD holder will pay interest on the day-to-day Contract Value. Conversely, the holder of a short CFD position will receive interest also based on the day-to-day Contract Value. Interest is typically calculated at a margin above or below the relevant Inter-Bank Offered Rate for long and short positions respectively.

Other than shareholder privileges, a CFD reflects all corporate actions affecting the underlying stock or share. The net dividend declared by a company will be paid to the holder of a long CFD on the Stock Exchange ex-dividend date. This will be advantageous in cash flow terms as the dividend pay date will normally be several weeks after the ex-dividend date.

Holders of short CFDs pay 100% of the gross dividend declared and this must also be paid on the ex-dividend date. These payments reflecting the dividend are made on the ex-dividend date as, all things being equal, the share would be expected to fall by the amount of the declared dividend per share. Similarly, bonus and rights issues and splits are replicated in the CFD on the corresponding 'ex-date'.


Why Trade CFDs ?


Equity CFDs offer a number of investment opportunities and strategies, some of which are unattainable in traditional share investing. They can be summarised as:

  • An alternative to traditional share trading
  • Providing economic exposure to a company’s share performance without taking or making physical delivery
  • Counterbalancing economic exposure on an existing physical share holding, i.e. as a hedging or risk management tool
  • Affording access to a wide geographical range of markets and exchanges
  • No Stamp Duty is payable
  • Delivering a geared return on the capital employed
  • Freeing-up capital not required for margin for other uses
  • Allowing you to close-out a position at any time
  • Potentially positive daily cash flows


Warning : CFD trading and spread betting can result in losses that exceed your initial deposit and is not suitable for inexperienced investors.



Questions : CFD FAQ's


What is an Equity Contract for Difference ?


A. An Equity Contract for Difference is an agreement made between two parties to exchange, at the closing of the contract, the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract.



What is CFD Contract Value ?


A. Every CFD has a Contract Value. It is the number of shares in the contract multiplied by the price of the underlying share. The Contract Value will change in line with the changes in the price of the underlying share. A CFD is marked-to-market (i.e. valued) daily at the close of business mid-price of the underlying share.



Do I have to pay the full Contract Value of an Equity CFD?


A. No, an Equity CFD is a Margined Transaction.



What is a CFD Margined Transaction?


A. A Margined Transaction is a transaction where the deposit of cash or other acceptable security (the Margin) is required to secure the performance of the obligations under the contract



What Margin is required for an Equity CFD ?


A. CFDs can be traded by providing Margin from 10% of the Contract Value. For example, if you want to open a CFD with a Contract Value of £25,000 you will be required to deposit £2,500. (If you are trading in an overseas market or one that has a history of price volatility the Margin required may be higher). The margin required may fluctuate from day-to-day in line with changes in the close of business price of the underlying share.



Can I buy or sell an Equity CFD?


A. Yes. You can buy (go ‘long’) a CFD and will make a profit if the value of the CFD increases.

Conversely, if you sell (go ‘short’) a CFD you will make a profit if the value of the CFD decreases.

The ease with which a short position can be established with a CFD is one of major attractions. It can be done without incurring the costs involved in dealing on a 'T+20' basis, i.e. there are no commission charged or Stamp Duty incurred in rolling positions forward. Consequently, CFDs provide an easy way to take advantage of a negative view on a share.

The examples below illustrate the features of long and short trades and compare them to traditional equity investments.



Why and how frequently is interest charged or credited?


A. When going long a CFD the economic aspects of a conventional share purchase are replicated. Accordingly, interest, calculated on a daily basis, on the Contract Value will arise.

On the other hand, with a short CFD position, a conventional share sale is simulated and interest, also calculated on a daily basis, will be earned.

Whether you are long or short the interest calculation is based on the day-to-day Contract Value is usually applied to the account weekly in arrears.

Interest is typically calculated at a margin above or below the relevant Inter-Bank Offered Rate for long and short positions respectively. The applicable rates will be notified in writing on opening the account.



What happens when a company pays a dividend?


A. The holder of a long CFD will receive, on the ex-dividend date, a payment that equates to the net dividend (i.e. having deducted UK basic rate tax) on the underlying share. This payment will be credited to the account.

A short CFD holder will, on the ex-dividend date be charged the gross dividend by way of a debit to the account.



Will I have to pay Stamp Duty when buying an Equity CFD?


A. No. As no purchase of the underlying shares is involved no Stamp Duty (currently 0.5% of the Contract Value) is payable.

Will I have to pay commission?


A. Commission is payable on the opening and closing of a CFD. Typically, the charge for each leg is 0.25% of the Contract Value. However, there are brokers that offer commission free dealing. They are able to make this offer by making their own, wider bid/offer spread around the price of the underlying stock or share.



What Spread can I expect to see in the bid and offer prices?


A. If commission is payable the CFD bid and offer prices should be the same or lie very close to the cash prices of the underlying share, as quoted in the relevant stock market.



What stocks are available?


A. It is possible to trade in any stock or share that forms part of the FTSE 350 listing, the S&P 500, Dow Jones and Nasdaq 100 and those traded on most of the European stock exchanges. In addition, most brokers will seek to quote CFD prices for other company’s shares, if the company’s market capitalisation is greater than £50 millions.



How often can I trade?


A. Provide an account is sufficiently funded it is permissible trade as frequently as desired. Trading will normally only be possible during the hours that the relevant stock market is open.



What is the minimum account-opening requirement?


A. £10,000 (or other currency equivalent) is generally the minimum amount required.



Is there a minimum opening Contract Value?


A. For CFDs based on FTSE100 shares the minimum is likely to be £10,000. A higher minimum contract value will often be applicable for lesser-known or some overseas shares or if the company has a modest market capitalisation.



Is there maximum opening Contract Value?


A. Only the cash in your account available to meet the Margin requirement and the ability of the broker to ‘borrow’ the underlying shares limits the maximum Contract Value.



How do I place an order for an Equity CFD?


A. You place an order for a CFD as if it were an ordinary share purchase or sale. As all trades are cash settled no instruction will be accepted unless there are sufficient cleared funds in the account or a credit facility has been pre-agreed by your broker.



Can I ask my stockbroker or someone else to place orders on my behalf?


A. This is normally possible, but will be subject to the completion of a ‘third party’ mandate by you and your stockbroker or the other party.



What trading strategies are commonly adopted?


Going long: - This is the simplest and most straightforward strategy. A long CFD will profit from an upward price movement in the underlying and has the benefit that no Stamp Duty is payable. There is no limit for the holding of a long position but, as explained below, there comes a point in time where a long CFD may become uneconomic.

Going short: - Also a simple and straightforward strategy and one of the principal attractions of CFD trading. By entering into a short CFD position a profit will be seen if the price of the underlying falls. Such a position can be maintained indefinitely without the need or the associated costs of having to continually roll the position over. Additionally, short positions generate an interest income but dividends are paid gross.

Hedging: - It is possible to offset an existing stock position so as to reduce market risk particularly in terms of a different time horizon to an underlying position. In other words, a trader may want to reduce exposure temporarily to a company but without effecting a sale of the physical holding.

Pairs trading: - While reducing overall market risk it is possible to obtain the out-performance of one share versus another by going long a CFD while going short a CFD, with a matching Contract Value, in a similar stock e.g. HSBC and Lloyds TSB. Examples are set out below.

Taxation: - There may be taxation reasons why a shareholder cannot or prefers not to sell a stock. CFDs are able to reduce short-term exposure by taking an offsetting position.

Changes in the Constituent Companies of an Index: - It is possible to take advantage of changes in the constituents of an index and the price volatility often seen by anticipating new entrants or departing companies from an Index.

Dealings by Directors & Other News: - A share price may move on news of directors buying or selling and these moves present opportunities that can be utilised with CFDs. Similarly, new information about a company, i.e. acquisition or merger situations, or its trading may generate price movements.

Speculative short-term trading: - Advantage can be taken quickly and inexpensively (in terms of trading costs) of individual views of a company’s likely share price movement.



Can I take or make delivery of a stock by trading an Equity CFD?


A. No. A CFD is a financial instrument linked to the underlying share price. You will not acquire any rights or incur any obligations relating to the underlying share.

How does an Equity CFD investment perform in comparison with a conventional share transaction?



A. A CFD is designed to mirror the economic performance and cash flows of physical share trading.



How does trading an Equity CFD compare with a conventional transaction?


This is best illustrated by examples below.



Is there a point in time when it becomes uneconomic to trade a long Equity CFD compared with a traditional investment?


Most CFD trading revolves around short-term trading so any comparison is best made by comparing the savings achieved by not incurring Stamp Duty with the financing cost of a long CFD. For ease of illustration, all commission costs are ignored and effective interest rate is taken as 6.5% (say LIBOR at 4% plus a 2.5% margin).

The additional cost of holding a long CFD position over a traditional purchase is only the interest cost. The interest charged on a long CFD is 6.5% of the Contract Value. The 10% lodged by way of margin is held to secure the performance of the contract and in not available to be set-off against the Contract Value. Conversely, a traditional share purchase incurs Stamp Duty at 0.5%.

The crossover will occur at the time that the interest charged on the long CFD match the saving made on Stamp Duty. This point is reached in 28 days – ((0.5/1.0) x (365/6.5)). However, this needs adjusting to allow for the fact that the Stamp Duty on the traditional purchase will be payable 3 days after the bargain date. Accordingly, the crossover occurs on day 25.

Consequently, for trades outstanding for less than 25 days it is economically more viable to trade the CFD rather than the underlying stock. The crossover point will occur earlier if interest rates rise above the 6.5% used in the example and be later in the event of a reduction in the interest rate. This is, of course, a basic calculation as there are other costs but for short-term or intra-day trading (and in the latter case there are no interest costs) the argument is undeniable.



How do I open a CFD trading account?


If you have an existing account to trade futures and options you should expect to have to sign a CFD supplement to the original Terms of Business. If you are new to CFD trading, you will be required to demonstrate prior experience of conventional share trading.

All brokers are required by the Financial Services Authority to satisfy themselves that the account holder understands the risks inherent in the leveraged or geared nature of CFDs.

Trading CFDs on margin is towards the higher end of the investment risk spectrum and it is possible to lose more than the amount originally invested. CFD trading is not suitable for everyone and if in any doubt, consult an independent financial advisor.



CFD Pairs Trading Examples


The following example leads in to one way that CFD's are sometimes used to hedge positions against stockmarket movements. This is just one way simplified that CFDs may be used in more complicated stockmarket risk management strategies

By trading a CFD Pair, it is possible to establish a balanced position while retaining sensitivity to market price movements.

CFD Pairs trading involves going long a CFD in one company’s shares with the contemporaneous shorting a CFD in another company’s shares. Both contracts should have the same contract value. The two companies will have a high interdependence, e.g. be in the same market sector.

The performance of a CFD Pairs trade is easily measured in terms of the ratio of the share prices. An increase from the original ratio will indicate a profit whilst a reduction in the ratio will indicate a losing trade.

For ease of illustration, the outcome of the trades in each of these scenarios is before taking account of interest (whether charged or earned) and trading commissions.



HSBC / Lloyds Banking Group CFD Example


An investor anticipates that the share price of HSBC Bank will outperform that of Lloyds Banking Group. The investor therefore opens CFD positions in HSBC and Lloyds Banking Group as follows :


  1. Buys a CFD for 10,000 HSBC shares at 900p (contract value £90,000, margin outlay £9,000)
  2. Sells a CFD for 15,000 shares in Lloyds TSB at 600p (contract value £90,000, margin outlay £9,000)

The price ratio is 900/600 = 1.500


The opening margin required for this pairs trade would be £18,000 (10% of the aggregate Contract Values).



Scenario 1

The price of HSBC rises to 930p and Lloyds TSB rises to 609p.

The price ratio is then 930/609 = 1.527

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Profit on HSBC trade £3,000 (10,000 shares x (930-900))

Loss on Lloyds TSB trade £(1,350) (15,000 shares x (600-609))

Net Profit on the trade £1,650



Scenario 2

The price of HSBC rises to 910p and Lloyds TSB rises to 640p.

The price ratio is then 910/640 = 1.422

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Profit on HSBC trade £1,000 (10,000 shares x (910-900))

Loss on Lloyds TSB trade £(6,000) (15,000 shares x (600-640))

Net Loss on the trade £(5,000)



Scenario 3

The price of HSBC falls to 850p while Lloyds TSB falls to 585p.

The price ratio is then 850/585 = 1.453

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Loss on HSBC trade £(5,000) (10,000 shares x (850-900))

Profit on Lloyds TSB trade £2,250 (15,000 shares x (600-585))

Net Loss on the trade £(2,750)



Scenario 4

The price of HSBC falls to 870p and Lloyds TSB falls to 535p.

The price ratio is then 870/535 = 1.626

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Loss on HSBC trade £3,000 (10,000 shares x (870-900))

Profit on Lloyds TSB trade £9,750 (15,000 shares x (600-535))

Net Profit on the trade £6,750



Scenario 5

The price of HSBC rises to 910p and Lloyds TSB falls to 535p.

The price ratio is then 910/535 = 1.701

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Profit on HSBC trade £1,000 (10,000 shares x (910-900))

Profit on Lloyds TSB trade £9,750 (15,000 shares x (600-535))

Net Profit on the trade £10,750



Scenario 6

The price of HSBC falls to 880p and Lloyds TSB rises to 635p.

The price ratio is then 880/635 = 1.386

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Loss on HSBC trade £(2,000) (10,000 shares x (880-900))

Loss on Lloyds TSB trade £(5,250) (15,000 shares x (635-600))

Net Loss on the trade £(7,250)




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