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The Benefits of Contracts for Difference

By: Caitlyn Caitlyn.   
Date Added : July 16, 2011 Views : 301

Most people are familiar with CFD trading which is gaining popularity because of a few convincing reasons. Therefore it is important that you get to understand what CFDs are all about as this will add a great deal to your trade skill and this may very well be your preferred trade platform. If you are a starter you need to understand the basics first so that you become familiar with the rewards contracts for difference can offer you.

The following guidelines will help you understand what contracts for difference are all about. This trade offers flexible instruments that allow you to go long and short, leverage your trade, and specifically hedge tour trade positions at just a fraction of the cost of the usual stock trading. In essence this trade is a binding contract between a buyer and a seller to pay the cost difference between the prices when a stock is bought and when it is sold.

A contract for difference investor is involved with speculating on the trade sentiment for the day and then buys or sells a certain quantity of a stock at some point during the trade. Whenever the buyer finds it fit, the trade is squared off at a net value totaling to the amount of the shares bought multiplied by the difference between the opening and closing price. In simple terms what this means is that when the buyer goes long and the stock closes higher, the buyer will make a profit out of the difference and inversely, the buyer will pay cash to the seller if they have gone short.

The benefits of contract for difference are many and it is predominantly suited for those who engage in short-term trades and they include, trade on margin. This means that you deposit an amount equivalent to only a small percentage of the total value of the trade. It reflects liquidity of the market and encourages low transaction costs. The brokerages in this instrument are far lower than those involved in buying stock from a regular trader.

Hedging on your stock portfolio by selling short enables people to take advantage of any short-term decline while keeping their portfolio intact and contracts for difference is also less of a hassle. With the advantages of contracts for difference, it means that the liquidity is not a problem, since they are not traded on the exchange. This means that when you place an order it will be executed at the price you want and this is done by the contracts for difference provider.

Price slippages are also possible with contracts for difference mainly because of the synthetic pricing fixed by the markets maker and not due to a lesser number of participants. However, in this case the participants are always pressured by the clients to provide even tighter spreads so that the chances of any losses are minimized.

The advantage of contracts for difference is obvious because if there is close linkage with the underlying price, it means that you will be able to arrive at a fair idea about your contracts for difference portfolio valuation through comparing the prices of the underlying. The prices of the underlying are displayed, and this makes it easier to estimate and analyze your contracts for difference portfolio.

CFD advantages also become obvious because of their very close linkage with the underlying price and that means you would be able to come to a fair idea about your CFD portfolio valuation through a comparison of the prices of the underlying. The prices of the underlying are displayed very commonly and therefore it is easier to estimate as well as analyze your CFD portfolio.

While on the subject of derivatives, it is worthwhile mentioning that there are similarities between options trading and CFDs since both facilitate leverage and also enable the taking of short positions by the trader to benefit from a falling market. But that is where the similarities end.

When Contracts for Difference (CFDs) were first introduced to Australia, there was no tax payable on income derived from CFD trading because they were treated as gambling. While many would say there is very little difference between Contracts for Difference (CFDs) and gambling the ATO did beg to differ. They very quickly introduced legislation that directly targeted Contracts for Difference (CFDs) before anyone could file a tax return.

Always Consult a Tax Advisor

When considering the implications of tax on CFD trading for your individual circumstances, you should always contact a tax adviser. Your specific situation may be unique and not covered by the guidelines below. The outline that follows is a general guide to the treatment of Contracts for Difference (CFDs) for tax purposes.

CFD Profit is Treated as Income

Any profit made when trading CFDs is treated as taxable income, and any losses made reduce taxable income. So the income for tax purposes is the net income calculated by adding up all your profits and taking away all your losses.

Deduct Your CFD Related Expenses

As with any business, whether you are a company or not, business expenses associated with CFD trading, such as platform charges, interest charges and internet access, may be deductible, reducing your taxable income.

Capital Gains Tax Does Not Apply to CFDs

While it would be highly unusual for a CFD trader to hold a position for 12 months or more, capital gains tax discounts do not apply to Contracts for Difference (CFDs). Franking credits do not apply to dividends received while holding CFDs and no tax benefit is available for franking credits.

CFD Tax Outside of Australia

There are a few things to watch if you are outside of Australia as well and once again tax advice from a local accountant is important. In New Zealand it may pay to trade Contracts for Difference (CFDs) through a different entity so you are not classified as a "trader" by the IRD which could potentially impact your investments. In the UK spread betting remains non taxable, but the penalty for a trader is a wider spread paid on each transaction.

The Last Word on Tax on CFDs

As with any investment, it is important to know your tax obligations, though these are not the first priority. Remember losing $1 to save 30 cents is a stupid investment decision.

Caitlyn Ridley is the author of this article on CFD. Find more information about CFD Trading here.

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