The Product
The contract for difference (CFD) is a contract between two parties to exchange the difference between the opening and closing price of a contract, as at the contract’s close, multiplied by the specified number of shares. It is a neat way to get exposure to the price movement in, among other things, a stock or index without ever owning the underlying instrument. If the share price goes up or down, you will make or lose money on the difference.

Like spread betting, this is an over-the-counter market, which means the counterparty is the product issuer. A guaranteed stop loss is similarly available at a premium. But unlike spread bets, the CFD aims to replicate all the financial benefits of share ownership except for voting rights. You will be entitled to dividend payments and, depending on your broker, will have full access to corporate actions, including rights issues and takeover activity. There are CFDs based on indices, currencies and commodities.

The CFD market now accounts for more than 20 per cent of trading by volume on the London Stock Exchange, and the product is now commonly offered by spread betting firms, CFD market makers, specialist brokers and online dealers. Since the first edition of this book was published in 2002, CFDs have expanded their coverage to include almost any market or any kind of asset. You can typically trade CFDs in all UK stocks with a market capitalization (share price × number of shares in issue) of over £50 million, in many US and European stocks, and in all major world indices.

The Market
The market attracts institutional investors, particularly the hedge funds - those freewheeling spirits that trade using sophisticated techniques in pursuit of absolute returns. The CFD enables them to take a position in equities without revealing their identities. By direct market access (DMA) through brokers you can, as a trader, obtain often keener prices than through spread betting firms acting as market makers, provided somebody on the other side is prepared to meet the trade, but your deals will have to be of a specified minimum size.

Not everybody has an appetite for DMA, where a commission must be paid and there is not the added liquidity which a market maker can bring. But unless you use DMA, you are often just as well off doing spread betting.

In recent years, private investors have become increasingly involved in CFDs, but, unlike on spread bets, CFDs are open only to intermediate customers under current FSA classifications, which means that to trade this product, you must have some experience and knowledge.

Trading
As with other derivatives, you will trade the CFD on margin. At the start of the trade, you will put up initial margin, which is often at least 10 per cent of the value of the underlying instrument. The smaller the stock size, the greater the initial margin required. The margin is on the high side for stocks outside the FTSE-100, and on the low side for indices.

If you have a long position in a stock, you will have to pay a financing charge. This may be, for instance, LIBOR (London Interbank Offered Rate), defined on Day 16, plus 1.5 per cent - for the outstanding amount above the margin. The rate payable is pro rata to the annual rate. If you have a short position, you will similarly be paid financing (perhaps LIBOR - 2.5 per cent) for this. If you close out your CFD intraday, financing payments will not apply, as for rolling online spread bets.

The CFD has no settlement date, unlike for futures and spread betting where the contract on expiry must be rolled over to the next one. As in spread betting, you will pay no stamp duty on your CFD purchase but, after you have held it for about 60 days, the amount that you saved this way compared with on shares is cancelled by your interest payments. From this time, it makes no economic sense to continue holding your CFD unless it is significantly increasing in value.

Unlike in spread betting, you are liable for capital gains tax on profits beyond your annual exemption level (£8,500 in 2006-7), and you may offset losses against future liabilities.