Make a difference how a CFD can boost your returns

An investor has a pot of cash to put into Royal Bank of Scotland. Here, a senior trader at ETX Capital, explains the benefits of using contracts for difference (CFDs) rather than shares.

WHAT IS A CFD?

A contract between two parties. In this case, an agreement to exchange the difference in value of RBS shares between when the contract is opened and when it is closed.

HOW DO THEY WORK?

CFDs allow investors to take long or short positions — in other words they are able to bet on whether the price rises or falls.

By going long, or buying, you profit from a rising market. By going short, or selling, you gain from a falling market.

WHAT ARE THE ADVANTAGES OF CFDs OVER SHARES?

There is no stamp duty; you can trade long or short; and you benefit from leverage, which means you can trade with a smaller amount of cash. For instance, £1000 invested in a CFD on RBS is the equivalent of £10,000 of RBS shares.

WHY?

To invest in CFDs a customer must pay a deposit, or a margin requirement, rather than the full amount the shares are worth. RBS has a 10% margin requirement which means £1000 up front would give an investor a position worth £10,000. To get the same exposure from shares would cost the full £10,000.

HOW DO YOU MAKE MONEY?

Take the RBS example above. If you bought £1000 of shares a 20% profit on those shares would increase the value of the shares to £1200 giving a profit of £200.

If you opened a position with a £1000 deposit using CFDs on the same shares you would have a position worth £10,000. If the shares still gained 20% you would make a profit of £2000 or 200%.

A CFD also lets you bet against RBS. You can go short on £10,000 worth of shares for a £1000 margin. If the stock drops 5% the profit is £500 or 50%, if it drops 15% the profit is £1500 or 150% and so on.

BUT YOU CAN ALSO LOSE, RIGHT?

Of course. If you "buy" £10,000 worth of shares with a £1000 deposit using CFDs and they fall 10% you lose £1000, or the whole deposit. If you held the shares rather than the CFD, you'd only lose 10%, or £100, as the shares would still be worth £900.