The reasons for the existence of CFDs are many and varied and they go some of the way to answering the question, “why you want to go to the trouble of setting up and trading a synthetic representation of an asset, instead of trading that underlying asset itself?”
A good place to start is the London equity market in the 1990s which is where CFD trading began. At that time, brokers (who don’t pay UK stamp duty on share purchases) began offering UK equity CFD products to those traders who would otherwise be liable for the 0.5% stamp duty on purchases of UK stocks. By not buying the underlying stock in their own name, traders could use CFDs to take on trading positions but incur lower transactional costs when doing so.
That aspect of the UK tax regime has changed little since the 1990s and traders with a shorter-term investment outlook continue to benefit from using CFDs to gain exposure to UK equity markets. But, whilst necessity to reduce costs proved to be the mother of invention, the growth of CFD use, out of the UK equities market into other asset types and other regions, reflects that CFDs have additional characteristics that make them popular to trade.
When trading CFDs, you the trader are not required to put up funds equating to the total value of the transaction. Instead you place margin with the other party such as a trading platform. That allows traders to get exposure to a larger trading position than if they had to fully fund their trade. A note of caution here – the principles of leverage apply to losses just as they do to profits.
Using CFDs means it is possible for you to ‘sell short’ a particular instrument. The P&L associated with your trading position will still be the difference between prices of your opening and closing trades, but you will in this instance make profits if the price falls, and losses if the price rises.
What can’t you do?
If you are holding a CFD position, and therefore are not actually in possession of the underlying instrument, your name will not be the one that appears on the register of shareholders and that means that some advantages of being a shareholder may be lost.
A holder of an equity CFD would not be entitled to the voting rights associated with corporate events. As the broker rather than the trader would be recorded as the holder of the shares and so it would be the broker, if anybody, that would be entitled to vote on events such mergers and takeovers.
The same logic extends to dividends on equity CFDs. If you trade into a long equity CFD position it is highly unlikely that you will receive dividends associated with the stock.
Financing costs are something else to factor in when trading on leverage. Taking a purchase (long position) as an example, the broker platform will record that it has gone into the market to make the trade to the full value of the holding. The cash used to do that will be reported as a negative balance on your trading account and will incur financing costs each day the position is active.
The terms associated with trading CFDs may differ across the respective broker platforms and comparison can be made using Broker Comparison link.