An introduction to CFDs

A Contract for Difference - or CFD - is an alternative way to speculate on shares within global markets.

When a CFD is arranged, both parties agree to exchange the difference between the opening price and the closing price of the underlying shares at the termination of the contract.

Traders will determine the number of reference shares at the beginning of the CFD. These reference shares refer to the number of underlying shares that are specified in the initial agreement.

At the end of the CFD, its performance is calculated based on the value of the underlying shares.

By entering into a CFD, you are not required to - and have no right to - acquire or deliver the physical shares that are associated with the agreement.

The reference shares in a CFD simply track the price movement of these underlying shares.

Calculating the contract value of a CFD is straightforward - the number of reference shares stipulated in the agreement is multiplied by the value of the underlying shares.

By investing in CFDs, you can choose to take either long or short positions.

Opting for a long position means that you will make a profit if the contract value rises.

Alternatively, taking a short position will see you gain if the contract value drops.

This means that you can take advantage of both rising and falling share prices.

The following is a worked example of a long trade.

You buy 3,000 CFDs in Marks and Spencer

The financing position on this arrangement works as follows:

A corporate action could occur which benefits your CFD - in this case, the amount will be credited to the account. For example, a dividend could be paid.

Marks and Spencer pay a dividend:

You decide to sell your CFD ten days after the opening position, when the value of Marks and Spencer shares has reached 570p. The interest payments over this period have totalled £31.90. Interest payable will vary because daily interest is determined based on the value of the position at the close of business.

In this example, the position closed as follows:

This is the net result:

The following is a worked example of a short trade.

As previously mentioned, traders can also choose to take short positions when trading in CFDs.

In this example, you have decided that the value of Marks and Spencer shares is going to fall. Alternatively, you could use this tactic to hedge your own Marks and Spencer shares to protect against a drop in value.

This means that you decide to sell the CFD.

Due to the short position you have taken, interest is credited rather than debited.

The financing works as follows:

A corporate action, such as a dividend paid by Marks and Spencer, will result in the account being debited.

Ten days after opening the position, you decide to sell the CFD. At this time, shares in Marks and Spencer have fallen to 540p and you decide to close the CFD and purchase the equivalent number of shares that are sold. Interest accrued in this time totals £4.60. The interest due will vary because daily interest is determined based on the value of the position at the close of business.

The position in this example closed as follows:

This is the net result:

It is worth noting that CFDs are not suitable for all investors because they are a margined product and traders could stand to lose considerably more than their initial investment, due to the leveraged nature of the investment.