11 Trading with Contracts for Difference (CFDs)

Introduction

Trading Contracts for Difference (CFDs) is a form of derivative trading widely used in the UK but illegal in the US and many other countries. The value of the derivative is exactly the same as the value of the share price that it is derived from at any point in time.  It allows trading on specialist platforms with high leverage – typically x 10.  This is known as trading on margin, effectively trading borrowed money.

It is estimated that around 30% of trading on the London Stock Exchange SETS is through CFDs.  Particularly significant is that in the UK, CFD trading is exempt from the 0.5% stamp duty applied on share purchases, and this is a significant advantage for any short-term trading strategy.  The viability of high-frequency or rapid trading would be significantly impaired if it was subject to stamp duty on buy orders.  This effectively means that there is a ‘two-tier’ system operating in the London markets, with traders working through CFDs and exempt from stamp duty, enjoying an unfair advantage over everyone else.

You can take both long and short positions on a CFD platform and also trade indices, such as the FTSE 100.  UK-based traders can take positions in overseas indices, such as the S&P 500, and in overseas shares.

There is no stamp duty or equivalent tax on buying shares in the US, and you can trade on margin, typically with x 2 leverage, through a stockbroker.  Higher leverage can be obtained in the US by trading derivatives on the futures markets.

Financial spread betting is a close cousin of CFD trading and also illegal in the US.  Spread betting is perhaps associated with more of a gambling mentality and is only briefly described here for the sake of completeness.

There is much confusion over the concept of a European financial transaction tax, with even prime minister David Cameron saying that the UK already has one in the form of stamp duty.  However, as a great deal of trading in the London market is through CFDs, a large amount of stamp duty – many billions of pounds worth – is avoided on this activity.  A tax on CFD trading would be a massive drag on trading in the London market – one of the reasons why it is so fiercely resisted.  A tax on the profit of each transaction has been mooted, but the practicality of this must be questionable. […]