Amateurs And Day Traders Are Being Attracted To Contracts For Difference

A contract for difference (CFD) is an agreement between two parties to exchange the difference between the opening price and the closing price of a contract, multiplied by the number of shares, as calculated at the contract's close.

CFDs are available on the top 350 stocks in the UK as well as on selected stocks in continental Europe and the United States. By investing in a CFD, you are not the registered owner of the underlying share, so you will not have shareholders' voting rights or access to product discounts. However, you are entitled to dividend payments.

You can trade CFDs on the internet or by telephone and will need an initial deposit of at least £10,000. CFDs are suitable for experienced investors. UK-based brokers will accept your business only on the basis that you understand the significant risks.

Like spread bets, CFDs are highly geared. You will buy on margin, putting up 10%-25% of your total investment, and effectively borrowing the rest from your broker. You will need to meet margin calls (market to market) initially from cash deposited in advance.

The broker will charge commission on CFD deals or will take its cut from the spread. The firm will also charge interest on the amount that you borrow in striking a purchase (taking a long position). The flip side is that it will pay interest once you have gone short on a position (for which CFDs, like spread bets, are ideal).

In either case, interest is usually slightly above base rate and is recalculated daily. You will not pay stamp duty on your CFD purchase but will be liable for capital gains tax on your profits. You can hold your position open in CFDs indefinitely, subject to playing margin calls and interest on loans. But typically, they are a short-term trading proposition.

Common trading strategies - You can use CFDs to your advantage where a fast gain may be possible, and for hedging purposes. Let me explain two such trading situations.

The first is to buy CFDs in stocks that are expected to enter the FTSE 100 index when its constituents are reviewed every quarter. At this point, companies with a market capitalisation below the 110th place are relegated from the index and others join it.
If you are to follow this strategy, you should buy a relevant CFD a few days before the index entrants are formally announced. You should sell the CFD the night before the stock enters the FTSE as, at this point, the share price often drops. In parallel, you could short stocks likely to be relegated from the FTSE 100 index and then reverse your position. To keep abreast of changes in the FTSE 100 index, visit the FTSE website (www.ftse.com).

The second strategy is dual trading, also known as spread trading. This is when you invest in the performance of one stock against another. You may buy a CFD in a stock that seems a likely out-performer and simultaneously go short on a stock that you think is overvalued. Traders often choose two stocks from the same sector that have historically reacted to the same industry issues and news. Using this strategy, you will broadly maintain a market-neutral position.

You will benefit from any share price rise in the stock you have backed for out-performance, while reducing the downside risk.

Choosing the right broker - When choosing your broker or bookmaker from the many available, look for fast execution of deals, competitive costs and access to high quality research.

Competition for CFDs - The London International Financial Futures Exchange (LIFFE) launched its universal future contracts (UFCs) in early 2001. It kicked off with 25 European and US blue chips [there are now 115], including France Telecom, Deutsche Bank and Microsoft.

UFCs are comparable to CFDs, although less flexible, and dealing may turn out to be cheaper. They have regulated clearing, through LIFFE (London International Financial Futures and Options Exchange), and offer a simple, low-cost way to gain exposure to international stocks.

Despite this, UFCs are currently of greater interest to institutional than private investors, although this balance is likely to change. For more information, visit the LIFFE website (www.liffe.co.uk).