Contracts for Difference
The US Securities and Exchange Commission (SEC) don’t approve of contracts for difference (CFDs), so you cannot trade them in the US, but they are available in many other parts of the world, including England and Australia. The name is fairly descriptive, as contracts for difference allow you to take out a contract on a something, and profit from the difference in the value of the thing over time. The something, or the underlying, can be practically anything you can think of, shares, indices, commodities, currencies, etc.
CFDs are a very recent idea, having been invented in London less than 20 years ago. It seems that they sprang out of equity swaps, which is a financial tool used by hedge funds and institutional investors. The equity swap can create a payment for a difference in the future between two sources of cash flow, but is quite often used by the professionals just to get around taxes and legislation. In a few years, CFDs became used by ordinary traders, moving out of the institutional markets.
Two great points about CFDs, particularly for English traders. As the contract is only for the difference in price, you never actually own any shares and so escape any stamp duty or capital gains, while benefiting from the change in price of the shares. And your CFD dealer has a huge list of underliers that you can trade on, which means you can trade on international markets which would normally be restricted to you, or which you would have to have accounts at other brokers to access.
CFDs are always cash settled, regardless of the underlying security or commodity, so there is no confusion such as you may possibly have when trading futures. You leverage your investment, just as with futures, needing a margin of 5% or 10% depending on the underlying and your CFD dealer. They are marked to market every day, so you can the subject of a margin call, and as with other leveraged investments, it is possible to lose a lot quickly if you are not careful about what you are doing.
Contracts for Difference are quite simply a great trading tool, and built specifically for traders to speculate. As with all derivatives that only need a margin to trade, you are in effect borrowing the rest of the cost of the underlying from your broker, so you must expect that your account will be charged interest for every day you are in the trade. If you are regularly trading, getting in and out of positions, this should not harm you too much. On the other hand, if you like the look of a share, but do not know if it will take off next week, next month or next year, then the interest could mount up, and you might be better off buying the shares directly, and not incurring the ongoing costs of a CFD.
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