The Meaning of CFD and How It Works

If you tried spread betting, you will find its similarities with CFD trading. In CFD, you are allowed to bet on the stock price without really owning the actual shares. The only difference between the two is that spread betting can be considered as gambling which is why it is free from stamp duty and capital gains tax. Whereas on CFD, only stamp duty is free.

The Meaning of CFD

CFD stands for Contracts for Difference and it is very popular especially among people who wanted to shift from spread betting. In some ways, CFD is the same as spread betting as it allows to bet on the stock price movement minus the actual ownership of the shares. But spread betting is free from other financial obligations like stamp duty and gains tax because it is also known to be a form of gambling. CFDs are not the same because you have to pay for the capital gains tax as stamp duty is free. However, either CFD or spread betting, both are allowed to be closed out any time you want.

How Do Contracts for Difference work?

Normally, you think that a stock price will go up from its current £100. You think that investing £1000 will be wise so you bought 10 shares. In case your prediction is right and the share price goes up by £120, you will get a profit of £200 excluding the charges for dealing.

But it is different with CFD trading. It allows you to gear up for more profits. Why? Because CFD providers will only ask you for a partial deposit, also known as margin, which is only about 10% to 20% of the actual price of the underlying asset. Therefore, if the margin is only 20%, your investment of £1000 will let you take up a bigger investment of £5,000, equivalent to 50 shares. Therefore, if your prediction is right and the price rises to 120p, then you will get a profit of £1000.

But then, if the chances of winning are higher, the chances of losing your investment are also high with CFD. Just consider it as buying a house under a mortgage. If you are buying a property worth £400,000 and the initial deposit is £80,000, the remaining £320,000 is the amount you borrowed. If the house value goes up by 10% then the house value becomes £440,000. The equity will also go up to 50%. However, if the price of the house goes down by 10% or £360,000, you will be on the losing end, half of your initial deposit will be lost.

The main advantage of CFD is that it doesn’t pay stamp duty. And if you don’t pay stamp duty, a bit of expense is taken from you. The money you suppose to pay for the stamp duty can go to another useful investment or it can add up to your current investment. Plus CFD is a margined product. You get to own a larger underlying asset without paying the actual price. Sounds enticing, right?