A CFD is simply an agreement to exchange the difference in value of a particular share between the time at which a contract is opened and the time at which it is closed.
Dealing CFDs is almost exactly the same as using a traditional stockbroker to buy or sell shares, including the same dealing price (except the CFD brokers who offer commission free dealing which is discussed in detail here). Look at this example to see what we mean.
- Two traders, Trader A & B, both believe that HBOS Bank will rise over the next few days
- Trader A will do the trade through his regular stockbroker
- Trader B will use Contracts for Difference
Trader A Uses A Stockbroker
- He calls his stockbroker at 11am and asks the current market quote for HBOS
- The broker quotes him £7.49 - £7.50
- He buys 1,000 shares at £7.50 and pays regular commissions and Stamp Duty (0.5%)
- He calls his CFD broker (see left hand margin for a list of CFD Brokers) also at 11am asking for a quote on HBOS
- The CFD broker quotes him the same price £7.49 - £7.50
- He buys 1,000 shares using CFDs at £7.50
- He pays commission on the deal but NO Stamp Duty (not levied for CFD transactions)
Who Owns The Shares In A CFD Transaction?
What is interesting in both of the above examples is that 1,000 shares in HBOS has been transacted on the London Stock Exchange by both brokers on behalf of their clients. But while the traditional stockbroker who's acting for Trader A has passed on the physical shares to his client, the CFD broker hasn't.
The CFD broker has instead kept the shares in his company's account but has made an agreement with Trader B to pass on 100% of both the profits and losses of the share price movement. In effect CFD clients are not interested so much in the physical shares, rather the profit and loss of the share price movement.
Look at it another way. If you bought 1,000 shares in HBOS on a Monday at £7.50 and sold them at £7.75 the following day what are you really interested in? The official share certificate from the company showing that you are the beneficial owner of 1000 shares, or the 25p profit per share? This is why CFDs are not meant for investment purposes and why they're so popular for quick short term trades - When a client uses CFDs it's not about owning the company's shares per se, rather owning the right of the share price movement.
What About Shorting Stocks
Because CFDs are all about making money on share price movements they are perfectly suited for shorting the market. If we again take the HBOS example. Trader A using his regular stockbroker cannot short shares because the London Stock Exchange does not offer this facility. But Trader B can easily use CFDs to short the shares.
- Trader B's CFD broker quotes him a market of £7.49 - £7.50 in HBOS
- He sells short 1,000 shares at £7.49
- 3 days later he buys the shares back at £7.29 making a profit of 20p per share or £200 excluding commissions
But how Trader B sell short shares he doesn't own? Because the shares sold are borrowed by the CFD broker. A Fund management company owns a lot of shares and while most people think there are only two ways for an Institution to make money with shares, there are actually three.
- The share price can go up
- The company can pay a dividend
- The shares can be lent (for a small fee) to another financial institution, in this case a CFD broker
- In order for Trader B to sell short 1000 shares in HBOS the CFD broker borrows shares from a Fund Management company
- These shares are then sold in the market
- When Trader B decides to cover his short position (whether at a profit or loss) he buys 1,000 shares which are then returned to the original owner
- It's a win-win-win for all three parties involved
- The trader has the ability to short, the CFD broker earns commission and the Fund Management company earns a small fee for lending the stock (this fee is normally taken care of by the CFD financing rates)