A guide to Contract for difference investing

What exactly is a Contract for difference?
Contracts for difference are a common derivative in the marketplace. When you own a CFD, you own a contract over the difference between the price that you bought the contract for and the current price of the contract, ie you own a contract over the performance of the share. That is, if you buy a contract for difference at $1.43 and the price rises to $1.55, then your contract is for the difference between the purchase price of $1.43 and the current price of $1.55, which is 12 cents in profit. If the CFD had decreased in value, then you would be obliged to pay the difference between the purchase price and the current price. As opposed to buying the stock, you purchase a contract over the movement in the stock price and this is revalued or "marked to market" in real time.

A Contract for difference gives you all the advantages of share trading without needing to physically own the stock. It is a contract that mirrors the performance of a stock or index, is traded on margin, and like physical shares your profit or loss is decided by the difference between the prices you buy and sell at. Contracts for difference also incorporate any adjustments for corporate actions, including dividends and stock splits.

What are the advantages of CFDs?
CFDs are traded on margin, which is a more efficient use of your money since you only have to allocate a small percentage of the value of the position to secure a trade, whilst still maintaining full exposure to the market. In effect it is possible to magnify the returns on your investment. CFDs brokers charge low commssions, which means that you do not have to pay high priced brokerage on either long or short transactions.

Since you are trading the price movement of the stock or index without physically owning it, it is as easy to sell a share or index CFD, as it is to buy it. This enables short selling to be done just as easily as buying a Contract for difference. Therefore a Contract for difference trader has the opportunity to profit from both bull and bear markets as well as short-term intra day movements.

Just as Contracts for difference emulate the price movement of the physical share market, they also mirror any corporate actions that take place in the underlying stock or index (dividends, stock splits or consolidations). Which means the owner of the share Contract for difference will collect dividends, and participate in stock splits, just as they would if they owned the physical share. It also means that if a share goes ex-dividend (meaning a dividend is due to be paid) while you're short a share, then you are obliged to pay for the dividend in that same way as if you are short the physical stock. You are not entitled to any voting rights because you do not actually own the stock.

Short selling Contracts for difference
Short selling using CFDs is the same as selling CFDs that you already own. There are no limitations on the way you transact Contracts for difference or on shortsellable Contracts for difference. It is possible to short sell any available Contract for difference however some Contract for difference providers may have a constrained short sell list and impose restrictions on the amount of a stock that may be short sold. You don't have to shortsell on an uptick like in the share market it is possible to shortsell at any price the stock is trading at. This offers major advantages over the traditional methods of short selling.

Tradeable CFDs
Most CFD providers offer Contracts for difference over the main sectors, major share indices as well as the stocks in the main share indices in the major markets. Many brokers offer thousands of different instruments in Australia, Asia, the UK, Europe and America.

Costs linked to CFDs
There is a small commission cost to open a Contract for difference position, the price of a Contract for difference will be the same as that of the underlying stock or index on the stock market. This means that buying a CFD is largely the same as investing in the underlying stock apart from the low price of brokerage, which makes Contract for difference trading ideal for those with low account balances.

Contract for difference positions carried overnight incur financing costs for the total value of the position. Traders who are long Australian Contracts for difference will pay interest and clients who are short will receive interest for their positions. The rate of interest payable is based on the cash rate for the country where the stock is listed. If the base interest rate of a country is lower than the financing cost charged by the CFD broker for going short no interest will be charged on short positions. An example of this is in Japan where interest rates are near 0%. In this case no interest is chargeable on short positions.

When you hold a CFD overnight, you are charged interest on the full value of the position because the CFD provider hedges your position by financing the purchase of the underlying stock in the market. They then pass on the interest to you the client at a premium. The interest rate charged depends on the market that is being traded. If you happen to be short a CFD, then you'll receive interest on the complete value of your position for every single day that you hold your position overnight. If you have a well-balanced trading system where you are short and long for around the same amount of time, you will effectively only pay only a small interest charge for overnight positions.

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Ben McGrath is a professional CFD trader. He trades with Australia's most popular CFD broker IC Markets. Ben has published a number of textbooks and guides on CFDs, you can download his most recent guide to CFD trading for free.

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