CFD Trading Guide: What are CFDs?

Posted By Marcus Holland On Tuesday, September 17th, 2013 With 0 Comments

What is a contract for difference?
A contract for difference (or a CFD) is a contract between a trader and a dealer. The two parties agree to pay the difference between the opening price of a trade and the closing price.

Who pays who?
If you make a successful trade then the dealer must pay you. But if the trade was unsuccessful then you must pay the dealer.

And what makes a trade successful?
Your job is to predict, for example, whether a share price will rise or fall. If you get it right then the broker will pay you the difference between the share price when you opened the trade and the share price when you closed the trade.

So if the share price changes by 10p then I would only be paid 10p?
No. Your return would depend on how many shares you had chosen to trade with. You would get 10p for each share.

If I want to make a tidy profit on a trade it seems that I’m going to have to deal in a lot of shares. Does that mean I’m going to have to stump up a huge wad of cash when I open a trade?
Not really. Let’s say you want to speculate on 5,000 shares that are on the market at £2 each. The value of the contract is £10,000 – ie £2 multiplied by 5,000. If you were buying the shares for real then you’d have to stump up the £10,000. But one of the key things about CFDs is that you can trade ‘on margin’. This means you will only have to provide a percentage of the £10,000 to make the trade.

So what exactly is a margin?
It’s the money you must put up when opening a contract for difference trade. It’s like a deposit. Normally, the broker will only ask for about 10 per cent of the contract value so in the example above your margin would need to be £1,000. So you’d be speculating on shares worth £10,000 with a deposit of £1,000. The ability to make large trades with a relatively small amount of money is called leverage.

Are shares the only thing I can make a CFD trade on?
No. Commodities, the foreign exchange and the major indices – such as the FTSE and Dow Jones – are also included.

Am I actually buying the shares?
No. Instead you are speculating on what will happen to the share price. Rather than buying the shares you are buying and selling a contract for difference. A CFD is known as a derivative. This is because the trade is based on (ie derived from) an asset without the speculator ever actually buying or selling that asset. If you owned the shares you could only make money from them if they had subsequently risen in value but with CFDs you can make a profit even when share prices are falling.

Okay, so what would I do if I thought the share price of a company was going to rise?

You would buy – it’s also called to ‘go long’. You would make a profit if you then sold after the shares had risen in value. But you would lose money if you sold after the shares had fallen in value.

So what would I do if I thought the share price of a company was going to fall?
You would sell – it’s also called to ‘go short’ – before you completed the trade by buying back the short. You would make a profit if your prediction was correct. You would make a loss if you had got it wrong.

How can I sell shares before I’ve bought them?
Don’t forget that you’re not actually buying and selling the shares at all – you’re opening and closing a trade that is based on the price of the shares. One of the reasons that CFDs are so popular is that they give you more flexibility than buying and selling shares for real.

Talk me through a simple example of making a profit on a contract for difference.

Okay. Let’s say you ‘go long’ on shares in Baggies International. You buy at £1 and you want the value of your CFD to be £1,000. At £1 per share, that £1,000 is worth 1,000 shares. Assume you then sold the shares later that day at a price of £1.10. The broker must pay you the difference between the share price at the start of the trade and at the end of the trade. The difference was 10p, which is then multiplied by the number of shares (1,000), making a profit of £100. Bear in mind that the broker will normally take a commission when you open and close your trade.

And how would I lose money on a CFD?
Say you go short on shares in Baggies International. Assume you sold the equivalent of 1,000 shares at a price of £1.10 per share. The shares strengthen that day and you cut your losses by ‘buying’ the shares back at a price of £1.25 a share. You will lose 15p per share – that’s a loss of £150.

Does the broker make some money even when I’ve made a profit?
Yes. The broker usually takes commission when you open a trade and again when you close it. The amount of commission depends on the value of the contract for difference. The broker would also have made money out of the spread.

What’s the spread?
Your broker always gives two prices when you’re looking at the value of a commodity, an index or a company’s shares. A CFD quote might, for example, look like this 500-502. The first price (which is called the ‘bid price’) is the price that you can sell at; the second price (which is called the ‘ask price’) is the price that you can buy at.

Hold on. Does that mean I always have to sell at the lower price and buy at the higher price?
Yes. Whenever you complete a trade you will always have paid the spread – also called the bid-ask spread. This is effectively a fee for the dealer.

So how does the spread work?
Let’s use a quick example. You are confident that shares in Company Random are going to strengthen. The CFD quote currently looks like this: 200-202. You go long and you must pay the ask price which is £2.02. Your prediction turns out to be spot on and the shares go up in value. The new CFD quote now looks like this: 205-207. You then decide to close the deal. You sell at the new bid price which is £2.05. The difference between what you bought at and what you sold at is 3p – even though the shares actually rose in price by 5p. The broker only pays you 3p per share so the spread has eaten into your profits.

I can see I’ve got less of a profit but I’m not sure how the spread has made the dealer any money.
This should help….the CFD quote for Company Random is 200-202 and imagine you bought the equivalent of 1,000 shares in the firm. You must pay the ask price of £2.02 per share. Let’s say you decided to sell them straight away. You wouldn’t sell them back at the price you bought them; you’d sell them back at the bid price which is £2. So you would have spent £2,020 and received £2,000 back. The missing £20 is the dealer’s fee. Remember, you always have to pay the spread. You will also probably have to pay commission.

When do I pay the commission?

You will probably have to pay commission when you open a CFD trade and again when you close it.

And how is the commission calculated?
The broker’s commission is based on the value of the CFD. Imagine you open a trade by buying the equivalent of 1,000 shares at a share price of £5. Your contract value is £5,000 (1,000 multiplied by £5). If the commission charged by your broker was 0.2% then the commission would be £10 – ie 0.2% of £5,000. (If the commission rate had been 0.1% then the commission would have been £5.) Let’s say you complete the trade that day by selling at a share price of £5.20. You would be selling back the CFDs at a value of £5,200 (ie 1,000 multiplied by £5.20) and the commission this time would be £10.40 – ie 0.2% of £5,200.

So how would the commission have eaten into my profits?
Your outlay was £5,000 and you received £5,200 back – so you’re up by £200. You paid £10 in commission when you opened the trade and you paid £10.40 when you closed it – giving a total commission of £20.40. You must now subtract the commission from your profit, so your total profit is £179.60.

Do I still pay commission when I lose money on a CFD?

How long can I hold a CFD?
That is totally up to you. But if you hold a position overnight then your CFD will be subject to finance.

What’s the finance on a contract for difference?
If you open and close a CFD trade in a single day then there is no finance. But the CFD is subject to interest each time you roll it over to the next day. If you have gone long you will pay interest. But if you have gone short you will be credited with interest.

Why does a contract for difference involve interest payments?

It’s because you’re trading on a margin. Say your margin is 10%, this means you can make a trade that’s worth £10,000 by putting down a deposit (or margin) of £1,000. Therefore, if you ‘buy’ shares the broker is basically lending you the rest of the money until you ‘sell’ the shares back. A CFD reflects the real market so you must pay the interest rate on this loan. If you open a trade by selling, then the roles are reversed and the dealer must pay interest to you.

How are interest payments worked out?
They depend on several factors.

  1. the price of the share at the close of the day’s trading
  2. the number of shares you’re dealing with
  3. the interest rate.

The interest payments are worked out every day and the share price will probably change every day so the amount of interest could also change every day.

How is the CFD interest rate decided?
The interest rate is based on the Libor – the London interbank offered rate. Another thing to realise is that the interest rate for a long CFD position is different from that of a short position. Let’s say the Libor stood at 5%; the interest rate charged by the broker when you’re holding a long position might be 7.5% while the interest rate credited to you while you’re holding a short position might be 2.5%.

How do I work out what interest I’ll pay?
It’s done automatically for you but this is how it’s worked out….
You take the current value of the contract, multiplied by the interest rate, divided by 365.
There are two key things to note.
Firstly, when you’re doing this calculation if the interest rate was 7.5% and you punched in 7.5 into your calculator before dividing by 365 then the result would be wrong. You must tap in 7.5 and then hit the % button so that the number is multiplied by 7.5% when it’s broken into a fraction ie .075.
Secondly, the 365 is used because that’s how many days there are in a year. The figure for some markets will be 360.

Give me an example of calculating interest.
Let’s say the market value of your contract is £10,000 (remember, this is worked out by multiplying the share price by the number of shares). The interest rate is 7.5%.
So…. £10,000 x .075 divided by 365 = £2.05. The interest payable for that day is £2.05.
Let’s say that the next day the shares rise in price and the contract value is now £10,074.
So…. £10,074 x .075 divided by 365 =  £2.07. The interest payable is £2.07 – a slight rise from the previous day.

Can the interest rate change while you are holding a CFD?

The contract value is £10,000 but I put down a £1,000 margin, so the ‘loan’ is effectively the remaining £9,000. Will the interest payment only be based on the £9,000?
It will usually be based on the entire contract value – so the full £10,000.

CFDs seem to mirror the real market, what about if there’s a share dividend in the company I’m trading in?
Most brokers take this into account too. If you have gone long on shares in Company Random then you will profit from a dividend to shareholders. But if you have gone short on Company Random then your account will be debited.

How is the dividend payment worked out?
The amount depends on how many shares you are dealing with and what the payout is per share.

So remind me, how do dividends and interest affect me when I’ve gone long?
You must pay interest – but you receive dividends.

And how do dividends and interest affect me when I’ve gone short?
You receive interest – but must pay dividends.

I think I’m ready for a full breakdown of exactly what might happen when I go long…

The CFD quote for Company Random is 198-200. You believe the share price is going to rise so you buy at (the ask price) £2. You want the equivalent of 5,000 shares which will make the contract value £10,000. You’re trading on a 10% margin which means your deposit for this trade is £1,000. The broker’s commission charge is 0.2% which means the commission for opening this trade works out at £20.
The share price rises consistently and after 80 days the CFD quote for Company Random is now 220-222. You decide the time is right to close the deal. You sell at the new bid price of £2.20 which means a return of £11,000.
Your gross profit for the trade is £1,000 but you must now take into account the commission and the interest. The commission when you closed the deal was £22 making the total commission £42. Because you took a long position you must pay the broker the interest for each day you had the trade open. That interest works out at £172. So the final figure is a profit of £786.

Can I have that information simplified please?
You must work out what you’ve earned and then deduct what you’ve paid. Like so….
You received £11,000 when you sold.
You paid £10,000 when you bought, £42 in commission, and £172 in interest. A total of £10,214.
£11,000 minus £10,214 means a profit of £786.

Can I now have a full breakdown of what might happen when I go short?
The CFD quote for Company Random is 400-402. You decide to sell and you want the equivalent of 10,000 shares (you must sell at the bid price of £4 which makes a contract value of £40,000). Your 10% margin means you must provide a deposit of £4,000. The broker’s commission charge is 0.2% which means the commission for opening this trade is £80.
Unfortunately for you, Company Random’s share price begins to rise – and keeps rising. The firm also pays out a dividend to its shareholders. After 40 days you opt to close the trade when the new CFD quote is 428-430.
You ‘buy’ the 10,000 shares (at the new ask price of £4.30) for £43,000 and you pay a commission of £86. The dividend was 10p per share so you must pay 10p for each of the 10,000 shares, making a payment of £1,000. But because you took out a short position you get paid the interest. Over the 40 days the interest accrued was £115.
You’ve lost £4,051.

Simplified please…
You must add up what you’ve earned and deduct what you’ve had to pay.
You earned….£40,000 from the initial short and £115 in interest. A total of £40,115.
You paid…….£43,000 when you bought back the short, £166 in commission, and £1,000 in dividends. A total of £44,166.
£40,115 minus £44,166 means a total loss of £4,051.

Can i ensure that I only ever lose a certain amount of money on a trade?
Yes. A ‘stop loss’ is designed to close a trade when you hit your agreed limit. The only time this might not be activated at exactly the right time is if the market is moving extremely quickly. A guaranteed stop loss order is a way of ensuring your losses don’t go over your limit.

What are the differences between CFDs and owning shares for real?

  1. CFDs won’t give you shareholder rights – shares will
  2. CFDs are usually traded on a margin – shares aren’t
  3. Financing charges can make CFDs a more attractive short-term trade – these charges don’t apply with equities
  4. You don’t pay stamp duty on CFDs – you do on shares
  5. CFD losses are potentially limitless – that’s not the case with traditional share trading.
  6. Going short is a major part of CFD trading – it’s not with stocks and shares

What are the differences between CFDs and spread betting?

  1. You can hold a CFD as long as you like – spread bets usually have a deadline by which time the trade must be completed
  2. CFD traders receive (or pay) dividends – they are not included in spread bets
  3. CFD trades are subject to overnight finance – they aren’t usually applied to spread bets
  4. CFD traders will pay a commission – spread betters won’t, though the spread will usually be wider to take account of this
  5. CFD profits are subject to capital gains tax – spread bet winnings aren’t
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