Contracts for difference (CFDs)
So why not buy the shares?
Well, you can buy a contract at a fraction of the face value of the shares - 10-25pc of the value. It is a much cheaper way of dealing shares, particularly if you are a frequent trader.
There is also the advantage of not having to pay stamp duty. However, you still have to pay capital gains tax on your winnings.
So does it work in practice?
Well, let's say you want to buy shares in BT the traditional way.
Your internet broker quotes you 500-505 (meaning he will buy them from you at 500p and sell them to you a 505p).
So you buy 1,000 at 505p shortly before the quarterly results.
The figures are good, the shares shoot up to 555p and you make £500 profit on the transaction.
But then of course you pay stamp duty on the deal and you had to stump up £5,050 to buy the stock.
Now a CFD trade would be slightly different.
You are given the same quote by the boker - 500-505.
You buy - but at a fraction of the price, say for the sake of argument, £505 (a not unrealistic 10pc of the face value).
The shares head in the same direction and you make a £500 profit on the investment, almost doubling your money.
So where do the shares fit in as part of a CFD transaction?
Unbeknown to you, the broker has only gone out and bought the shares. In total, 1,000.
But rather than passing them on to you, he keeps them in a company account and simply passes on the profits, or God forbid the losses from the share movement.
Shorting
You have a very good hunch that a share price is about to go down, or that the company is overvalued.
As I said earlier, CFDs are a favourite among those wishing to sell short in the maket (for a definition of shorting click this link).
Take the BT example again. Your internet stock broker says there is no chance of taking a short position.
Basically, there is no facility to sell stock you don't have. So you call your CFD broker and he says no problem.
Why? Well quite simply, the CFD brokers have found away around the problem, thanks mainly to big fund managers who lend them stock for a fee.
Right, I know your head is starting to hurt
But lets look at the mechanics. Instead of buying, you sell BT at 500p.
As you predicted, the results weren't so good and the shares drop to 450p.
At this point you cover off the short position, netting a £500 profit on 1,000 shares.
In order to sell short, the CFD broker had to borrow 1,000 shares from a fund manager, which are then sold in the market.
When the short position is covered out, the stock is bought back and returned to fund manager.
What will it cost
You would normally expect to pay commission charges of 0.25pc of the face value of contract for both opening and closing a transaction. Some brokers offer commission-free dealing, but you will find this is offset by the poorer buying and selling terms.