Contracts for difference (CFDs) have gained popularity exponentially since their
introduction to the Australian market in 2002. In their first four years since
introduction CFDs grew to claim between 5 and 20 per cent of the market
(depending who you ask). In the UK, where CFDs have been around since
1974, CFDs are estimated to account for 40% of the daily volume of the
London Stock Exchange; all indications suggest that CFDs could become
just as popular here in Australia.
What are CFDs?
A CFD is an over the counter contract to exchange the entry and exit price of a
specific share or index. CFDs are leveraged instruments – securities that provide
exposure to the performance of the underlying share or index, without actually owning any shares.
They allow you to bet on upward or downward movement of the underlying share or index without actually needing to own that underlying security. Your profit or loss is made up of the change in the share (or index) price as well as commissions, fees and interest. CFDs allow you to bet long (that the price of a share or index will rise) or bet short (that it will fall). Short selling (or “shorting”) is particularly popular for CFDs.
CFDs can be heavily leveraged – up to 20%. You can buy CFDs on some shares with a margin of as little as 5% - that is, you only pay 5% of the actual face price of the CFD contract. This can mean big wins if you punt the right way, but it can also mean big losses if the market works against you – you can lose much more than your initial investment.
CFDs contrast from trading in options in this way, because with options you can only potentially lose the cost of the options.
CFDs were originally developed as a trading vehicle for large institutional traders, but are now accessible to individual investors, which brings potential risks to inexperienced traders.
Spread Betting has attracted some court attention in Australia over whether or not to define it as betting. Spread bets are defined as a derivative under the Corporations Act. In March 2006 the Victorian supreme court ruled that spread betting was a valid financial service under federal law, and therefore spread bet providers do not need to hold a gambling licence. It also means that spread betting at this stage doesn’t benefit from the tax implications of being defined as gambling.
In the UK spread betting is and has been regarded as gambling for around 40 years.
The difference between CFDs and spread bets basically rests on the period they last – spread bets have a fixed time limit, where CFDs don’t. With spread bets the broker nominates the expected price of a particular share at a future date and the customer takes out a bet or contract against that price.
What next?Learn about Australian CFD providers, or more contracts for difference information.