Contracts for Difference Basics
Interested in Contracts for Difference trading? "What is CFD?" - I hear you cry. Well, if you’re interested in answering these questions then you came to the right place. CFD trading might appeal to you because you’re someone who doesn’t want to have to buy and sell any actual assets, but still interested in speculating on the financial markets. If this is the case then CFD trading might offer the perfect approach for you, so, without further ado, let’s take a look at what’s involved. If you buy and sell contracts for difference, then you are performing CFD trades. A CFD is a derivative product, so-called because they are “derived from” other investment vehicles that are traded on the financial markets like commodities, currency pairs and shares.
What makes CFDs unique is that when you trade in them you don’t actually take ownership of the assets themselves. No shares, shipments of frozen orange juice or Australian dollars ever need change hands. What you do instead when you trade a CFD is that you agree to exchange the difference in price of an asset between two points; the first one being when the contract is opened and the last one when it is closed. One of the most appealing things about CFD trading is that price movements in each direction allow you to bet on what’s going to happen. You’ll make a profit or loss depending on how well you manage to forecast which way those prices our going to move.
As we’ve said, this kind of trading is about gambling on price movements over time. If you buy something like a house, then you are obviously going to hope that its market value goes up. But with CFD, you can actually profit if the underlying value of the market goes down. This is what’s known as ‘going short’, or selling. When you bet that an asset will increase in value it’s called ‘going long’ or buying. As an example of this, let’s think about some Microsoft shares. If you have a hunch that their price is going to fall, you could sell a share CFD on the company. You will still be exchanging the difference in price between when your position opened and when it closed, but you’ll make money if the shares lose value and lose money if they gain value. All In both cases, your actual gains and losses are settled when you close the position.
CFD trading is leveraged, this makes it possible for you to (in a manner of speaking) gamble with more chips than you actually own. For example, let’s say you want to open a position that’s equivalent to 400 Microsoft shares. If you are doing a standard trade, you would have to pay for all of them right from the get-go, but a leveraged CFD trade can put you in the game for as little as 5% of that total cost. It’s easy to see that leveraging is so popular because it allows traders to take what capital they have and make it go a lot further, but if you only have just one cautious bone in your body, this approach should be ringing clear alarm bells for you. Leveraging may enable you to squeeze the most out of your capital, but it can also exponentially magnify your losses—to ruinous levels. That’s because both profit and loss is still calculated according to the full size of your position. In our example, that would be the difference in the price of 400 Microsoft shares from the moment that the trade was opened to the moment when it closed. It’s not difficult to see that profits and losses can both be vastly magnified in comparison to the size of your initial outlay, and that losses can vastly exceed it too. This is why it’s incredibly important to remain aware of the leverage ratio and never lose sight of the fact that you should trade within your means. People who forget this have lost billions.
Leveraged trading is known as ‘trading on margin’ because the amount you need to open and maintain a position—the ‘margin’—is only representative of a small proportion of its total size. In CFD trading, margins come in two varieties. There’s the deposit margin that you need to open a position, and there’s a maintenance margin, which is something you might need if it looks like your trade is about to accrue losses your funds and deposit margin can’t cover. This is when your provider will be on the phone to you asking you to top up your account. Failed to do so and your position will be closed, and your losses realised.
You can also use CFDs to hedge against losses in your current portfolio. For instance, if you own shares from a company called XYZ and you think they’ll be losing value for a while because of some issue affecting the business, a CFD trade could help you out. This will let you go short on the market, offsetting the loss you might incur. It’s like a seesaw really. Play your cards right, and the two could balance each other out. Hedging your risk this way means that if the XYZ shares took a tumble, your short CFD trade would show an equal profit to counter it.
You can close CFDs any time you want, assuming the market is open. But with futures, you’re contractually obliged to trade a financial instrument at a fixed point and a fixed price in the future. This future trade can require you to take actual ownership of the physical goods being traded on this date, which will have to be bought on an exchange. The value of futures contracts hinges as much on the way the market feels about the future price of this asset as it does on any fluctuations in the current market. It’s worth remembering that our CFD trading account lets you speculate on the price of futures contracts with no need to purchase the contracts themselves.
You should now have more of a grasp of what CFDs are. Next, we’ll consider how they work by looking at four of the underlying concepts: spreads, profit/loss, deal sizes and durations
There are two prices to a CFD, the buy price and the sell price.
The sell price (also known as the bid price) is the price at which you can open a short CFD
The buy price (also known as the offer price) is the price at which you can open a long CFD
Sell prices are always slightly less than the present market price, while buy prices will always be a little above it. The amount that separates these two prices is called the spread. Usually, the spread absorbs the cost of opening a CFD position, which means that buy and sell prices will shift in accordance with what it costs to make the trade. It’s worth noting that this isn’t true of our share CFDs though, because we don’t charge using the spread. In contrast, our buy and sell prices the same as the price of the underlying market, so we charge commission when you open a share CFD position. This approach means that CFD trading will feel much more like your usual share trading experience.
Unlike options, the majority of CFD trades don’t have a fixed expiry date. By contrast, the way to close a position is with a trade that’s in the opposing direction to the one that opened it. A buy position of 200 silver contracts, can be closed by selling 200 silver contracts. Keeping a daily CFD position open beyond the cut-off time, will incur an overnight funding charge for you. The amount of the charges based on how much money your provider as effectively lending you by letting you keep the leveraged trade open. This doesn’t always happen, as you will know if you’ve ever taken out a forward contract. These have an expiry date and any overnight charges that you might incur are already accounted for in the spread.
CFDs are traded in uniform contracts known as lots. Individual contract size will vary according to the basic asset that’s being traded and will often mimic the way that the asset is being traded on the market. For instance, A standard lot in gold is equal to 100 ounces. and its equivalent contract for difference is also valued at 100 ounces. With share CFDs, the size of the contract is normally equivalent to a single share in the company, so if you want to open a position that is on a par with buying 300 Chase Manhattan Bank shares you buy 300 Chase Manhattan Bank CFD contracts. It’s because of this kind of numerical parity that CFDs seem more like traditional trading than other derivatives.
If you want to work out how much profit or loss you’ve earned from a CFD trade, then multiply the total number of contracts in the deal by the amount of each contract (expressed per point of movement). After that you just need to multiply your figure by the how many points difference there are between the price at the time of opening the contract and at the time of closing it.
Profit or loss = [ quantity of contracts * volume of each contract ] * [closing price - opening price]
To get a complete figure for the profit or loss from a particular trade, you’ll need to subtract any charges or fees that you incurred. Things like overnight funding charges, commission or guaranteed stop fees all need to be included.