CFD - what is this?

T is not widely known that the popular contracts for difference (CFDs) first appeared more than 30 years ago, in the volatile post-crash environment of the late 1980s. At the time, professional investors were keen to find a tool which would help them focus the risks in their portfolios and protect them from market falls. A pioneering product was developed called an equity swap, which allowed these investors to short sell individual stocks with leverage.

While the fund managers were rejoicing, private investors were unable to get access to this product. That was until 2002, when contracts for difference came along, specifically designed for private investors. For the first time, individuals were able to access markets and structure their investments with the same flexibility and efficiency as the professionals. CFDs provided a level playing field for private investors.

Since then, CFDs have boomed in popularity among private investors around the world. In the UK, the London Stock Exchange estimates that CFDs now account for almost half of all stock trades that pass through the exchange. Quite a compelling figure.

The same trend has occurred throughout Europe, Australian, Japan and Singapore. It seems that CFDs are meeting the needs of private investors like no other trading tool has done before.

So what are CFDs and what makes them so popular?

A contract for difference is an agreement between two parties to exchange the difference between the price of the underlying asset at the time the position is opened and the price at the time the position is closed, multiplied by the number of units of the underlying asset detailed in the contract.

CFDs look and feel like the underlying equities they reflect. The only difference is that the investor doesn't 'own' the underlying stock and so doesn't get to vote at annual meetings - but everything else is the same.

The benefit for investors is that CFDs are generally cheaper to trade, require only a fraction of the investment (that is, they are traded on margin) and can be used to 'go short' as well as 'go long'. This means you can actually make money if a stock falls. Or - and this is the real reason smart investors are using CFDs - you can straddle both short and long positions and protect yourself from market downturns, such as we have seen in the recent financial crisis. This style of investing is called 'market neutral' investing. It is new to private investors, but professional investors and hedge funds have been making use of equity swaps in this way for 30 years. It's the modern style of investing and CFDs are what allow private investors to do it.

While CFDs were initially restricted to individual stocks, some providers now offer CFDs over other asset classes such as index futures, commodities and foreign exchange.

Basically, CFDs bring the world of investing to your fingertips, from one account and one online trading platform which is available 24 hours a day.

Contracts for difference allow investors to gain leveraged long or short exposure to equity, index, commodity or forex markets without the obligations and expense of ownership.

But note that not all CFD providers are alike. There are two basic models that providers follow - market-maker and direct market access.

Market maker providers do not necessarily hedge their clients' CFD trades in the underlying market. Many clients have complained that this model is less transparent and that the provider is not accountable for the prices and liquidity they provide. A market maker model opens up the possibility that the provider has a conflict of interest with their client - that is, the provider may benefit when the client loses.

In contrast, the direct market access (DMA) model has gained popularity because the provider automatically hedges clients trades in the underlying market - immediately. This means that clients can see their trades in the 'course of sales' of the underlying exchange and orders appear in the official order book. This ensures client orders benefit from the fairness and accountability of exchange queue priority. Basically, the DMA CFD model is more accountable and more transparent. A DMA provider does not benefit when its clients lose money.

An interesting trend in the CFD industry is that professional investors such as hedge funds and trading houses have begun moving back to CFDs and turning away from the predecessor instrument, equity swaps. CFDs have evolved to such an extent in meeting the needs of private investors that professional investors are realising they also satisfy their more sophisticated requirements. It's a rare scenario - professional investors discovering that private investors are being better served.

But that sums up CFDs - an innovative product that is turning the world of investing on its head. If you haven't discovered CFDs yet, it's time you made some inquiries, before the world leaves you behind.