CFDs, forex trading and spread betting are highly speculative products, which for the vast majority of retail investors involves a high risk of losing some or all of their money.
What is a Contract For Difference (CFD)?
A Contract For Difference (CFD) is a highly risky financial contract that’s based on the price difference of an asset between opening and closing trades on a stock market. The contract is created between a trader and, usually, either a spread betting firm or an investment bank.
CFDs don’t have an expiry date and can be held indefinitely, however, due largely to the wide spreads and overnight fees for any position held overnight, holding a CFD for long periods can incur significant additional costs.
For this reason CFD trading typically involves a very short-term timeframe and deals are often closed the same day are rarely kept open for more than a few days. This makes CFDs different to the longer-term ‘buy-and-hold’ approach associated with conventional stocks and shares investing. This is one of the reasons that CFD trading carries much greater risk than regular investing and is more akin to gambling.
Providers that wish to offer products involving the use of CFDs, or other similar high-risk products, to retail investors in the UK are overseen by the Financial Conduct Authority (FCA). InDecember 2022, the FCA wrote to CFD providers, reminding them of their high-risk nature, and that they must take action to mitigate the various risks they present, including the risk that, ‘adverse price movements in relevant markets can lead to substantial losses for consumers’.
How do CFDs work?
CFD providers typically offer traders exposure to a range of global markets including currency pairs (forex trading), stock indices, commodities and shares.
Traders can then speculate about whether the asset’s price is going to rise or fall. The accuracy of that prediction largely determines whether a trader makes a profit or a loss.
A CFD investor who thinks an asset’s price is going to rise will buy a CFD, or ‘go long’. One who thinks the price will fall will look to sell the CFD, or ‘go short’.
CFDs are classed as a derivative which means traders do not own the underlying asset they are looking to bet on. Instead, they are exposed to price movements associated with that asset. Capital Gains Tax is not payable on any profits made from CFDs as the asset is not owned by the investor. However, please be reminded that tax rules are dependent on one’s individual circ*mstances and may be subject to future change.
At the end of the contract, relevant parties exchange the ‘difference’ between the opening and closing prices of the asset concerned.
More on risk and CFDs
CFDs are a ‘leveraged’ product, which means traders only need to deposit a small percentage of the full value of a trade to open a position. However, this works both ways and investors risk losing not only that money, but could potentially lose all of the money they may have deposited in an account with the CFD provider.
For example, a £100 bet that the oil price will rise could lead to a loss of more than £100 if the oil price were to fall. The further the oil price fell, the more money the trade would go on to lose. The vast majority of CFD traders lose money.
