Part 4 - When should I use a CFD?

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All the big CFD providers offer thousands of markets, including indices, forex, commodities and more. Some markets such as gold or oil are 'expiry transactions' which means they have a fixed expiry date, so if you have not closed such a position by its expiry date, it will close automatically.

Other CFD markets operate in a similar fashion to share CFDs. One key difference is that with share CFDs you trade at the underlying market price and pay a small commission on your trades, but with our other markets there is no commission to pay - the only charge is the dealing spread.

Although CFDs are a quick, cheap and efficient way to trade they are nonetheless to be handled with extreme care since you could find yourself holding a position up to 20 times greater than would be possible with a traditional investment.

Trading CFDs can be used in a variety of ways. Say you want to hedge your share portfolio against further downturns. You can use an Index CFD to do so. If, for example, your portfolio is particularly heavy on blue chip UK stocks, you can hedge against any further downswings by going short on the FTSE 100 CFD contract.

Doing this will mean that any further losses on your stocks would be neutralised by the gains on the short index position. Usually, the value per index point of one CFD equals one unit of the base currency - pound, dollar or euro. This means that if the FTSE was trading at 6,000, an investor who wished to hedge a diversified UK blue chip portfolio worth say, £60,000, would need to short 10 contracts.

Step 1 Opening a position

In this example we show an index-based CFD with IG Markets. The FTSE 100 has been hovering around 6,000 all week. You think it is due for a fall because of the European debt crisis and fears over the fall-out from the Japanese earthquake, and want to protect your UK blue chip portfolio that is primarily invested in FTSE100 companies.

So, you decide to take a 'short' position. Here's how to do it with IG Markets who is quoting 6001 bid/6002 offer.

You sell two contracts at 6001 (with IG one contract is the equivalent of £10 per index point). There is no commission to pay.

To open your position you need to put down a deposit of £300 per contract - in this case the total you have to put down is £600 to cover your two contracts. You will then make or lose £20 for every point the buy price falls below or rises above 6001.

Step 2 Closing the position

The market falls sharply the next day and then continues steadily downwards for the next few days. IG's quote falls to 5928/5929 and you decide to close your position and take a profit by buying two contracts at 5929.

Your profit on the trade is calculated as follows:

Opening level 6001

Closing level 5929

Difference 72

Profit: 72 points x two contracts x £10 per point = £1,440

Remember, this is how much you would lose if you sold the market, it went against you, and forced you to take a 72-point loss.

To calculate the overall result you also have to include interest and dividend adjustments. Interest adjustments are applied daily to stock index trades in exactly the same way as to Share CFDs. Dividend adjustments are applied whenever a stock in the relevant index goes ex-dividend.