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What is CFD trading?

What is CFD trading? It's a question that many first-time people ask, whether they are trading Forex, stocks or commodities. 

A CFD, or Contract for Difference, is an agreement between two parties to exchange the difference between the opening price and closing price of a contract.

CFDs are derivatives products – contracts whose value is based on or derived from a traditional security, such as stock, bond or assets like foreign currencies and commodities.

What are the advantages of CFD trading?

Simply, it allows you to trade on live market price movements without actually ever owning the instrument – stock, bond, etc – that the contract is based on.

CFDs are used to speculate on the future movement of market prices regardless of whether the underlying markets are rising or falling. What does this mean? Unlike buying shares in a company, in which case you only make money from the value increasing, with CFD trading you can make money on the contract falling or rising.

If you think prices are falling, you can go short (ie sell) and watch the market fall. You then buy back the contract at the lower price and pocket the difference. If you anticipate prices will rise, you buy (go long) on a contract and then sell once it's worth more.

Why bother going long? One word – leverage. CFDs are leveraged products, which mean you can trade by paying just a small fraction of the total value of the contract. As with all leverage, your potential gains are magnified, but so are your potential losses.

Because you can go long or short on a contract, CFDs are a lot more flexible than traditional trading instruments, such as buying a share in a company. The other point to note about CFDs is that - unlike "futures contracts", they can remain open for as long as you wish - there is no need to "roll them over" every quarter, so if you are using them as a hedge (see below) they are cheaper to manage than pure futures contracts.

CFD trading: hedging and tax

Say you own £10,000 worth of shares in BT, you can short sell the equivalent using CFD trading to hedge your portfolio. This is possible because CFDs are leveraged.

Are CFD trades tax efficient? Yes is the answer. CFD trading can be very tax efficient as it's possible to use losses (they do happen in trading!) you incur to offset against your Capital Gains Tax (CGT) liabilities. NB that this cannot be done if spread betting under current UK legislation however.

Remember we said earlier that CFDs are a derivative product? So, this means you don't actually own the underlying instrument. Therefore, because you don't actually own anything, you are not liable to pay stamp duty in the UK, effectively saving you 0.5% on the value of each trade.

Tax laws vary from country to country, so you need to check with your own jurisdiction. Even in the UK, CFD trades involving Irish stocks are still charged 1% stamp duty.

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