Furthermore, CFDs are traded on margin, enabling you to trade with only a percentage of the cost of the underlying financial instrument and to leverage your position. Please be aware however, that CFD trading carries above average risk and is not for everyone, so please ensure you fully understand the risks involved. You should be aware that it is possible to lose more money than your initial deposit and that you may be required to make further deposits at short notice. You should not engage in CFD trading unless you understand the nature of the transaction you are entering into, the risks involved and the true extent of your exposure to the risk of loss. Please see the Risk warning section.

 

Background

CFDs originated in the UK in the 1980s. They were initially introduced by investment banks as an efficient mechanism through which institutional investors could hedge their exposures.

The CFD product was subsequently adapted from the institutional market and brought to a general audience in the 1990s and retail investors now have the opportunity to participate in all the benefits that CFDs have to offer. In light of this, CFDs have become extremely popular which is demonstrated not only by the number of new specialist firms offering CFDs, but also by their trading volumes.

CFDs are now regulated in Europe, Australia, New Zealand, parts of the Middle East, Singapore and Canada. The UK is the most mature CFD market in the world and it is estimated that there are around 2.5 million CFD trades executed every month. As with any derivative, positions need to be hedged back to the physical market. Through various direct and indirect methods, it is thought that CFD hedges account for as much as 40% of all trades on the London Stock Exchange (LSE)*.

It is likely that that more countries will regulate CFDs in the near future and that there will be strong growth patterns wherever they are available to be traded.

* Source: David Stevenson, The Motley Fool, July 2007

 

Derivative products

CFDs are financial derivative trading products. This means their prices are derived from the prices of other underlying financial instruments. When you buy or sell CFDs, you will not physically own any shares, commodities, currency, treasuries or other underlying instrument. You will actually hold a contract with Spread Co to exchange the difference in price between where you enter the trade and where you exit the trade.

Pricing

CFDs are priced almost identically to their underlying instruments and are typically quoted on a spot basis. This means that CFD prices move in real-time as the prices of their underlying instruments move on the relevant exchange on which they are quoted or in the inter-bank market.

 

The Spread

The spread, also known as "the dealing spread" or "the buy / sell spread", is the difference between the prices at which you can buy and sell the CFD in which you want to trade.

The spread is how market makers such as Spread Co are compensated for creating a market for you to trade CFDs. A wide or large spread is more expensive to you. A narrow or small spread is cheaper to you.

Spread sizes vary by instrument depending on:

• the liquidity of the underlying instrument
• the volatility of the underlying instrument
• the amount of freely traded shares that exist for the relevant underlying instrument

The size of the spread represents how much the market must move in your favour before you begin to make a trading profit. For example, if you buy 1,000 Tesco CFDs at a 0.5p spread, your trade will begin at a £5 loss.