Mechanics

A CFD has a contract value - defined as the number of shares in the contract multiplied by the price of the underlying reference share. For example if ABC Corp is trading at 160p, then 1 CFD is equal to 160p. Simple.

Just like with traditional investing, there are always two parties to a CFD: the buyer (also known as the long party) and the seller (also known as the short party). The long party opens the contract by buying the CFD; the short party opens the contract by selling the CFD. And just like with traditional investing, if the price of the CFD rises then the long party (buyer) will make a profit. If the value of the CFD falls, then the short party (seller) will make a profit.

CFDs have the added advantage of gearing or margin trading, which means that you only need to deposit a small amount of the total contract value.

As mentioned above, holders of the CFD do not pay the full underlying value of the contract. Instead they are required to deposit funds (known as margin) as collateral. Margin is calculated as a percentage of the contract value, and as CFDs are marked to market (valued based on current market prices) on a daily basis, the client is responsible for maintaining the agreed margin rate of the contract value plus any loss as a result of re-evaluation. See our jargon buster later on for more help with margin.

For example, if you want to get an economic exposure to £10,000 worth of ABC Corp. shares that are currently trading at 1.23 / 1.25, then you would purchase 8,000 CFDs (1.25 x 8,000 = £10,000). Assuming a margin rate of 10%, you would only have to put up £1,000 initially to gain exposure to this £10,000 position.