July 29, 2014

Contracts for Difference Explained

Contracts for Difference (CFDs) are similar to spread bets. A CFD can be opened based on the price of shares when the contract started. The contract acts an agreement to pay out cash on the difference between the starting price of the share and when the contract is eventually closed. A key difference between CFDs and Spread Bets is that spread bets are classified as gambing, and as such are exempt from stamp duty as well as capital gains tax.

Here is a simple example to illustrate CFDs

  1. Company X currently has a share price of 200p each.
  2. You believe that Company X is going to grow further, and expect their share price to further increase.
  3. Therefore, you buy a ‘long’ CFD against 20,000 shares in Company X. Your broker asks you for 20% of the value of the contract, so you have to pay over a deposit of £8,000. Overall, the contract is worth £40,000 and will rise should the shares increase in price.
  4. Disaster strikes as Company X reveals troubling product news. Shares in Company X have just fallen in price to 100p each.
  5. The difference in the prices within your contract is now £20,000 but in favour of the CFD broker. Not only have you just lost your £8,000 deposit, but must also pay out £12,000 to cover the contract.
  6. You are left with the choice of closing the CFD now, or continuing the contract in the thought that the price of the shares may go back up. However, if the share price continues to fall, then you will be left owing even more money to the broker.

However, if the share price increased by the same amount, then it would be the broker paying you £20,000 minus associated charges.