What is a CFD?
A CFD or a contract for difference is a form of derivative trading. With CFD trading you can speculate on the rising or falling prices of financial instruments like shares, indices, currencies, commodities and so on.
The biggest benefits of CFD trading is that you can trade on margin. Also you can short (or sell) if you believe that a price of an instrumental asset will go down or go long (buy) if you believe it will increase. Another clear advantage in the UK is that CFDs are tax efficient which means that you won’t need to pay stamp duty. CFD trades can also be part of an hedging strategy for an existing physical portfolio.
How does CFD trading work?
The first thing to understand when dealing with CFD trading is that you don’t actually buy or sell the underlying asset (like a physical share, currency pair or commodity). If you believe the price will go up or down you can buy or sell a number of units of a determined financial instrument. CFDs are offered on a huge range of global markets and CFD’s instruments do include currency pairs, shares, treasuries, commodities and stock indices like for example the UK 100 which is the equivalent of the price movements of all the stocks that are listed in the FTSE 100.
When you are dealing with CFDs for every point the price of the instrument moves in your favour you will gain multiples of the number of CFD unites you have acquired or sold. If however the price will move against you, than you will make a loss and those losses can also exceed your deposits.
For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss. Please remember that losses can exceed your deposits. This is because you can trade with leverage.
CFDs are leverage product. This means that in order for you to trade you only need to make a small deposit: this will be a percentage of the full value of the trade you need in order to open a position. This kind of trading is also called ‘trading on margin’ or margin requirement. Trading on margin has the benefit that you can start getting into action and trade with a low deposited capital: this means that your returns can be magnified but same as the losses if the markets will move against you: this is why you could win more money that you have deposited but on the other way you could lose more than any capital invested.
What are the costs of CFD trading?
The cost of CFDs trading is the spread which is the difference between the buy and sell price. When you enter a buy trade you get a buy price quoted and when you exit you use the sell price. The narrower is the spread, the less the price that you would need to cover before you start to make profit or if the price goes against you a loss. It is important to pick CFD brokers that have consistent competitive spreads.
What are the holding costs?
At the end of each trading day the position open in your account can be charged by some CFDs brokers with an ‘holding cost’. The holding cost could be positive or negative and this will depend on the direction of your position and the holding rate that will be applied.
What are market data fees?
Some brokers do charge a fee to trade or view price data for share CFDs. This charge is called market data fees.
Are there any charges if trading shares?
Some brokers do charge a separate commission when you trade share CFDs. Normally commission for UK-based shares do start from 0.10% of the full exposure of the position and the minimum charges are in the region of £9.
What are the instruments that you can trade on CFDs?
When you trade on CFDs you can take a position on more than 100,000 CFDs instruments. You can trade most forex pairs and also trade lots of different shares, stocks, commodities and so on. It is important to check how many assets a broker allow you to trade: the more the better as it will open up more opportunity for you.
Can you have demo accounts to learn trading on CFDs?
Sure and it is advisable that you try your strategies before risking any capital. Although on CFDs the opportunities of making profits are great the risks of incurring in huge losses are are also significant. This is why it is important to familiarise with your broker’s trading platforms and test your style before start trading with real money.
Example of a CFD Trade
Let’s say we are going to buy a company share in a rising market (going long). UK Company A is at 98/100: that means that you can sell at 98 pence and you can buy at 100 pence. In this example the spread is 2. You believe that the company price is going to increase so you open a position buying 10,000 CFDs or ‘units’ at 100 pence. Company A has a margin rate of 3% which means that you only need to deposit 3% of the total value of the trade to be able to open that position: in the example your position margin will be £300 (10,000 units x 100p = £10,000 x 3%). This is great but if the price moves against you you can lose a lot more than your margin of £300. Let’s see the possible outcomes:
1 – Profitable trade
Let’s say you got it right and the price increases to 110/112. At this point if you decide to close your buy trade you can sell at 110 pence. The price in this case has moved 10 pence in your favour: if you multiply the number of units you have bought (10,000) your profit will be of £1,000.
2 – Losing a trade
In this case unfortunately the prediction you made was wrong and the price of the Company A went down to 93/95. You believe the drop will continue and you decide to stop your losses by selling at 93 and close the trade. In this scenario the price has moved 7 pence against against you so you have to multiply this number by the units you bough (10,000) and your loss is therefore £700.
How do short-sell CFDs in a falling market?
One of the good things about CFDs is that it does allow you the opportunity to sell (short) a financial asset if you have the feeling that it will decrease in value. If you get the prediction right you will be able to make a profit from the downward price move. If things go in the right direction you will than buy the asset back at a lower price and by doing that you will lock a profit. If however, the market goes in the opposite direction and the value of the asset starts to rise than you will make a loss and this loss can also exceed you deposits unless you have set some stop loss limits.
How can you hedge your physical portfolio with CFD trading?
Let’s suppose you have invested in an existing portfolio of physical shares with another broker and you believe those might lose some value in the short term, a strategy that you can use is hedge your physical shares by using CFDs. In this scenario you will short sell the same shares as CFDs and than you can try to make a profit from the short-term decrease in value. This will have the aim to offset any loss from your existing portfolio.
But let’s make an example so you get the concept more clear: let’s imagine you hold £5,000 worth of physical A Company shares in your portfolio. With CFDs you can hold a short position or short sell the same value of A Company. If A Company shares start to fall the loss of your physical share could be offset by the profit you will make on your short selling CFD trade. You can than close the CFD trade to lock your profit when the short-term decrease in value come to an end and the value of your physical shares starts to rise once again. Using CFDs to hedge physical share portfolios in a very popular strategy used by many traders especially when the market is volatile.