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CFD Trading Explained

 

What are Contracts for Difference (CFD)s

 

The term CFD stands for Contract For Difference. This is a contract to exchange the difference in value of a financial instrument (the underlying market) between the time at which the contract is opened and the time it is closed.

 

Cfds are traded just like normal shares. The prices quoted by many CFD providers is the same as the underlying market price and you can trade in any quantity just as you would with an ordinary share, you will usually be charge a commission on the trade and the total value of the transaction is simply the number of CFDs bought or sold multiplied by the market price. However, there are some distinct differences from trading ordinary shares that have made them increasingly popular as an alternative instrument to speculate on the movements of shares or indices. (Best CFD Trading Site)

 

Advantages of Contracts For Difference (CFDs)

 

Contracts For Difference (CFDs) are traded on margin so you can maximise your trading capital.

No Stamp duty is payable (saving 0.5% compared to a traditional share purchase).

You can profit from falling or rising markets by trading long or short.

A single account can give you access to far greater range of financial markets.

You can limit & Manage your risk using a Stop Losses and Limit orders.

Risks of Contracts For Difference (CFDs)

 

The geared nature if margin trading markets means that both profits and losses can be magnified and unless you place a stop loss you could incur very large losses if your position moves against you.

It is less suited to the long term investor, if you hold a CFD open over a long period of time the costs associated increase and it may be more beneficial to have bought the underlying asset.

You have no rights as an investor, including no voting rights.

Key Features of Contracts for Difference (CFDs)

 

Traded on margin

 

Rather than pay the full value of a transaction you only need to pay a percentage when opening the position called Initial Margin. The key point is that margin allows leverage, so that you can access a larger amount of shares than you would be able to if buying or selling the shares themselves.

 

The margin on all open positions must be maintained at the required level over and above any marked to market profits or losses in order keep the position open. If a position moves against you and reduces your cash balance so that you are below the required margin level on a particular trade, you will be subject to a “Margin Call” and will have to pay additional money into your account to keep the position open or you may be forced to close your position. (Best CFD Trading Site)

 

Trade in rising or falling markets

 

CFDs allow you to trade LONG or SHORT. A Long Trade is where you BUY an asset with the expectation that it will rise, just as you would when buying a normal share. A Short Trade is where you SELL an asset that you do not own in the expectation that the price will fall and you can buy the asset back at a cheaper price. Shorting in the ordinary share market is almost impossible. With CFDs, however, you can go short as easily as you go long. Giving you the ability to profit even if a share price falls if you trade the right way. (Best CFD Trading Site)

 

No Stamp Duty

 

Because with CFDs, you don’t actually physically buy the underlying shares, you don’t have to pay stamp duty. Saving 0.5% when compared to a traditional share deal.

 

Commission

 

Commission is charged on CFDs just like on an ordinary share trade, the commission is calculated on the total position value not the margin paid.

 

Overnight Financing

 

Because CFDs are traded on margin if you hold a position open overnight it will be subject to a finance charge. Long CFD positions are charged interest if they are held overnight, Short CFD positions will be paid interest.

 

The rate of interest charged or paid will vary between different brokers and is usually set at a % above or below the current LIBOR (London Inter Bank Offered Rate).

 

The interest on position is calculated daily, by applying the applicable interest rate to the daily closing value of the position. The daily closing value is the number of shares multiplied by the closing price. Each day’s interest calculation will be different unless there is no change at all in the share price.

 

Trade Shares and Indices

 

CFDs allow you to take a view on shares and indices and some CFD providers also allow trading on currencies and sectors.

 

Risk Management Facilities

 

Because of the higher risk nature of trading on margin, many CFD providers offer comprehensive Stop Loss and Limit Order Facilities so that Investors can manage their risk in fast moving markets.

 

How do Contract For Difference (CFD) work

 

The best way to demonstrate how a CFD works is to look at some key examples:

 

Share CFD Example: Long Trade

 

A long trade is a position that is opened with a buy in the expectation that the share price will rise.

 

Vodafone is currently trading 140 – 140.5

 

Investor A believes that Vodafone is going to rise and places a trade to buy 10000 shares as a CFD at 140.5p. The total value of the contract would be £14050 but they would only need to make an initial 10% deposit (initial margin) £1405.

 

The commission on the trade is £28.10 (£14050 x .20%) and because they are buying a CFD there is no stamp duty to pay.

 

A week later Investor A’s prediction was correct and Vodafone rise to 145 – 145.5 and they decide to close their position. By selling 10,000 Vodafone CFDs at 145p. The commission on the trade is £29 (£14500 * .20%).

 

The profit on the trade is calculated as follows:

 

Opening Level 140.50p

Closing Level 145.00p

Difference 4.50p

Profit on trade, (4.5p x 10,000) £450.00

Overall Profit

 

To calculate the overall profit you must take into account the commission and financing charges on the deal, remember with a “Short” sell the financing charge is credited to the holder.

 

Profit On Trade £450.00

Commission -£57.10

Financing Charge £12.50

Overall Profit On the Trade £380.40

Share CFD Example: Short Trade

 

A short trade is a position that is opened with a sell transaction in the expectation that the share price will fall.

 

Barclays is currently trading at 555 – 556

 

Investor B believes that Barclays is over valued and is going to fall and places a trade to SELL 2000 shares as a CFD at 555p. The total value of the contract would be £11,100. Even though they are selling short, they would only need to make an initial 10% deposit (initial margin) £1,110. The commission on the trade would be £22.20 (£11,100 x .20%)

 

A week later Investor B’s prediction was correct and Barclays falls to 545 – 546 and they decide to close there position. By Buying 2000 Barclays CFDs at 546p, the commission would be £21.84.

 

The profit on the trade is calculated as follows:

 

Opening Level 555.00p

Closing Level 546.00p

Difference 9.00p

Profit on trade, (9p x 2,000) £180.00

Overall Profit

 

To calculate the overall profit you must take into account the commission and financing charges on the deal, remember with a “Short” sell the financing charge is credited to the holder.

 

Profit On Trade £180.00

Commission -£44.04

Financing Charge £ 3.80

Overall Profit On the Trade £139.76

Index CFD Trade Example

 

Although indices are not quoted like ordinary shares with a BID and ASK price, CFD providers will quote a BID and ASK price for index CFDs and allow you to trade indices as a CFD.

 

The FTSE 100 is currently trading at 4890 and XYZ CFD.com is quoting a spread of 4887 – 4893 on the FTSE.

 

The price of 1 CFD is £4890., because of the size of an Index Trade and the reduced volatility when compared to an individual share the margin requirements are usually lower, we have used a margin level of 5% in this example.

 

Investor A believes that the FTSE is going to rise and buys 3 Index CFDs at £4890. A total value of £14670, the margin required is just %5, £733.50.

 

A week later the FTSE has risen and the daily FTSE spread is now 4990 – 4996

 

The profit on the trade is calculated as follows:

 

Opening Level £4,890.00

Closing Level £4,990.00

Difference £100.00

Profit on trade, (£100 x 3) £300.00

Overall Profit

 

To take calculate the overall profit you must take into account the commission and financing charges on the deal, However not all CFD providers charge commission on Index CFDs.

 

Stop and Limit Orders

 

Because of the geared nature of trading on margin it essential to have access to facilities that let you open or close positions if certain levels are reached.

 

Limit Order

 

A Limit order is one that is executed at a better price than the prevailing market price, i.e. for a Long CFD Trade when the stock drops to a certain level or for a Short CFD Trade when the stock rises to a certain level.

 

Example: Vodafone is currently trading at 140 – 140.5

 

Investor A wishes to buy 10000 Vodafone as a CFD with a limit of 135, therefore they do not wish the order to be opened unless Vodafone reaches 135.

 

This order is held by the CFD Provider until the limit level is reached.

 

The next day the Vodafone is 135 – 135.5 and an opening trade of 10000 Vodafone is opened at the limit level of 135.

 

Stop orders

 

A stop order is one that is executed at a worse price than the prevailing market price one of the most common uses of this is a stop loss order. It is possible to make substantial profits when trading CFDs as well as substantial losses which is why many CFD providers allow you to place a stop loss when you open a trade:

 

Stop Loss

 

A stop loss is a price level set by the client on a particular trade that if reached automatically closes out the particular position at the desired price.

 

Example: Lloyds TSB is trading at 467 – 468

 

Investor A and Investor B both believe that Barclays will rise and both buy 2000 Lloyds TSB at 468 as a CFD. However, Investor B also places a stop loss when he opens the trade at 457

 

The following day Lloyds drops steeply during the day trading down from 467 to 430.

 

Investor A has not been watching the price of Lloyds all day and therefore when he checks the price at the end of the day it is now 430 – 431 and he is running a £750 loss. Investor B has not been watching the market either however his position has been automatically closed out at his stop loss level of 450 limiting his loss to just £200.

 

A stop order can also be used to open a trade for instance if you wished to open Long CFD position you may wait until a stock was moving in the right direction and set a level higher than the prevailing market price.

 

CFD Trading Strategies

 

Short Term Trading

 

The ability to gear up your trading capital by trading on a margin combined with no stamp duty make the CFD an ideal instrument for short-term trading.

 

Hedging

 

You can also use a CFD to protect your long-term holdings against variable market conditions. It may be cheaper to open a short CFD position in the shares rather than sell the physical shares in order to buy them back later.

 

Pairs Trading

 

If you believe that one company is undervalued compared to another company (e.g. Barclays against Lloyds) you can use CFDs to go long on the cheaper stock whilst going short the more expensive stock.

 

Tax Efficient Trading

 

If you have a holding of physical shares you can sell CFDs against this without crystallising a potentially taxable capital gain. This enables you to control the time at which you realise capital gains or losses and may reduce your tax liability.

 

Remember that CFDs are a leveraged product and can result in the loss of your entire deposit. Trading CFDs may not be suitable for you. Please ensure you fully understand the risks involved.