What are CFDs?

CFD's stands for Contracts for Difference

The "contract" is an umbrella term used to describe all the financial products that City Index offer. Currently you can trade contracts on stocks all over the world, including the UK, Europe and the US.
You can also trade CFDs on currencies, stock indices as well and commodities.

The CFD works exactly the same way that you treat for example a physical share purchase. Your profit or your loss is determined by you entry and your exit price. A CFD operates on exactly the same principle and in many respects are identical to for example physical share trading.

However, there is one major difference between for example a physical share trader and a trader using CFDs to buy the same shares. The physical share trader essentially buys a piece of ownership of the company he purchases. The CFD trader doesn't get any ownership. As such any CFD contract is purely driven with the view of speculating on the direction of for example a stock or a commodity. It is not used to acquire ownership of the instrument in question.

CFDs are hugely popular amongst private retail traders and institutional investors. They are used for all sorts of trading activities, and have actually been the preferred trading instrument by many UK based hedge funds.

Let's take a closer look at why CFDs are so popular.

1. CFD's are exempt UK Stamp Duty
2. CFD's allow the user to "sell short"
3. CFD's are traded on margin

When an investor wants to purchase shares in a UK company, they have to pay 0.5% to the UK Treasury. This is called Stamp Duty, and it is applicable on all share purchases in the UK. However, anyone who buys the share as a CFD does not pay Stamp Duty - because they are not perceived to own a part of the company. For this reason many hedge funds will speculate in the direction of shares using CFDs because they save themselves the Stamp Duty.

Another reason for its popularity is the ability to "sell short" shares. This is the expression used to describe anyone who sells shares using CFDs, with the view of buying the shares back at a cheaper price. A current example of a stock which attracted many "short sellers" is Northern Rock. As the stock fell from its highs, many CFD traders "sold short" Northern Rock, hoping to capitalise on further falls.

Another major factor contributing to the popularity of CFDs is the ability to trade shares on margin. This means that the trader puts down a deposit on his account rather than paying for the full value of his purchase. Margin for stocks is generally 10% or lower. So for example the CFD trader who buys £5000 worth of shares in Vodafone only has to deposit £500 on his account.

What are the costs of trading CFDs?

When it comes to trading CFDs, there are two immediate costs that has to be taken into consideration.

1. Commission cost
2. Cost of holding positions overnight - funding rate

The commission cost is easy to explain. It is a fixed percentage of the value of your transaction. If the commission is 0.2%, and you purchase 10,000 CFDs in a share that cost £2.00, then you the value of your transaction is £20,000, and the commission will be 0.2% of the value or in this case or £40.

The other cost is known as the "cost of carry". When you trade on margin, you are essentially borrowing funds to trade. Cost of carry is split up into two items:

1. The buyer of a CFD contract will pay nightly interest
2. The seller (sell short) of a CFD will receive nightly interest.

The cost of holding a position overnight is common practise when you trade stocks on margin. The cost is based around the interest rate in the country of the stock you are trading. So if you are trading UK shares using CFDs, you will pay UK interest rates. If you trade US shares, you will pay the rate of interest as set by the American Central Bank, called the Federal Reserve.

The reality is so that you will pay a small premium above the interest rate when you are long, and you will receive the interest rate minus the premium when you are short.

At the current interest rate of 5.5%, it is a good rule of thumb to expect to pay 25 pence per one thousand pound of position in a UK share, and you can expect to receive roughly 10 pence when you are short, per one thousand pound position. The value of your position is valued at the close of the trading day, and will of course from one day to the next.

What does margin mean for my trading?

Margin is another word for collateral. City Index wants you to deposit funds to provide a cushion for any potential losses you may experience. It is for your safety and for ours as well. It is meant to ensure that any loss you may experience is within the means of your account.

We operate two kinds of margins:

1. Initial Margin
2. Variation Margin