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A CFD (Contract for Difference) is an over the counter agreement between two parties to exchange the difference between the opening and the closing price of that contract at the close of the contract based on the underlying share multiplied by the number of shares specified in the contract. Despite sounding like it is going to be very complicated it is in fact easy to come to terms with. Financial institutions and hedge funds have used CFD for more than ten years in the UK stock market as an alternative means of investment to traditional stock market trading. CFD trading is similar in many ways to spread betting in that the both of them are margined products so you can gear yourself up or actually take a decision that is a multiple of your available funds.

For example, if the margin on a firm youre interested in was 10%, establishing a position of £100,000 would really only require a deposit of £10,000. Any running profits you make can be used as margin to establish new positions but any running losses would have to be made good by reducing your position or providing additional funds.

While the stamp duty of 0.5% on all UK share purchases has in the opinion of some traders reduced the cost effectiveness of ‘day-trading’ traditional stocks and shares, both CFDs and spread betting are exempt and this has added to their appeal. CFDs are liable to capital gains tax whereas spread bets are tax free, but losses incurred from spread bets are gone for good while CFD losses can be offset against any future profits for the purpose of tax. When you actually trade in CFDs you purchase those contracts in nearly the same way you buy shares. So if you wanted exposure to 1,000 shares in a company, youd have to sell 1,000 contracts at, say, 494p per contract rather than simply placing a £10 per point bet with spread betting to get a similar return.

A lot of CFD providers allow you to post orders anywhere within the bid offer spread whereas spread betting firms post their own two-way, take it or leave it price in the same way a bookie would. With CFD you are the cost maker, which is why hedge funds tend to use CFDs rather than spread betting. CFDs do not enfold the costs of financing a position within the spread (as does spread betting) but charge those costs and commissions separately. With CFDs the charges and commissions involved in a trade are not part of the spread, which is the case with financial spread betting. Because of this, the CFD spread quote will forever be very close to the underlying price of the share or commodity that you are following. CFD’s also mimic almost every aspect of actually owning the underlying share or market, so if you hold a position long enough, you receive the benefit of any dividends being paid on the underlying shares.

Ultimately there is no hard and fast rule as to whether CFDs or Spread Bets are ‘better’ – you just need to understand the differences as each will be suited to different investing styles. Although they should not be regarded as substitutes for long term investment or saving, as more people seek to take control of their financial destiny, theres been a growing realisation that going short is a legitimate means of trading in market thats become increasingly difficult to profit from in a traditional sense.