How do CFDs work in trading
In order to understand how CFDs (Contracts for Difference) work first we need to know that in the majority of cases they are over-the-counter (OTC) transactions, that are based on the change in price of an underlying asset, such as a commodity like gold. It’s important to remember that you don’t own the underlying asset, you are actually making a contract financial instrument based on what you believe the change in price will be.
The CFD works to create profit (or loss) by capturing the price difference between the opening and closing position. CFDs also use leverage to magnify this price difference; this is one of their great advantages though leverage can be a double edge sword as it can both magnify profits and losses.
The range of leverage available is quite wide and depends on a number of factors such as the CFD provider, the underlying asset and the rules and regulations of the legal jurisdiction you are trading in.
Here is a practical example of how a CFD might work, with an underlying asset being shares of company ABC Ltd.
Initial Margin: Shares of ABC Ltd are quoted at a price of $5.00. You want to buy 2,000 shares as a CFD at this price.
The CFD provider has set the margin of the CFD at 20%, meaning the margin you will need to provide is 20% x $5.00 x 2,000 = $2,000.00
This is opposed to if you were to buy the underlying shares, which would cost $5.00 x 2000 = $10,000.00
So for the contract for difference, exposure to the price movement in this case required $2,000.00 on margin.
Profit example: The price of the underlying asset, Shares of ABC Ltd, increases to $5.10 during the days’ trading.
Profit = 2,000 x (5.10 – 5.00) = $200.00
This represents a ROI of $200/$2,000 of 10% for this trade, as opposed to $200/$10,000 = 2% ROI if you bought the shares themselves.
Loss example: The price of the underlying asset, Shares of ABC Ltd, decreases to $4.90 during the days’ trading.
Loss = 2,000 x (4.90 – 5.00) = $(200.00)
This represents a Loss ROI of -$200/$2,000 of -10% for this trade, as opposed to -$200/$10,000 = -2% loss ROI if you bought the shares themselves.
This example shows the profit and loss that can be incurred from trading a CFD (Contract for Difference).
There are other important factors that have a practical impact on how CFDs work. Some of the most important of these are:
Spreads, Fees and Commissions
These are very important as they affect your profitability in trading. Spreads are commonly used by CFD providers to make money (this is the main way most providers profit). Basically, what this means is the sell price for a CFD will be slightly lower than the current market price, and the buy price will be slightly higher than the current market price. These small differences, or ‘spreads’ are fees that you pay to your CFD provider.
On some underlying assets, some CFD providers charge a commission rather than a fee. This is somewhat like brokerage for buying shares.
This can be a tough one to get your head around initially but you’ll find it makes sense as you progress as a trader. Contracts for difference are typically traded in lots, or standardized contracts. Normally, but not always, these ‘lots’ mimic the way the underlying asset is traded on the market (for example, typically one share = one contract.) This is not always the case and hence you need to do your research before trading any particular asset class.
Duration of CFDs
CFD trades normally do not have a fixed expiry unlike other financial instruments like options. An open position for a CFD is closed by placing an opposing trade; for example an open buy position of 500 silver contracts is closed out by selling 500 silver contracts.
Typically CFDs are short-term intra-day trades, but if you do hold a CFD open position overnight most brokers will charge you an overnight funding charge, which relates to the leverage the CFD provider has given you.
As you can see from these examples, the leverage involved in CFDs makes a big difference to the size of the profit or loss of your capital. This is what makes CFDs such an attractive proposition to some traders and speculators. The example given is if you are taking a long position in a CFD, in other words if you are expecting the price of the underlying asset to increase. You can also take a short position if you are expecting the price to drop (see my article here for more information about shorting CFDs. CFDs are an effective way to gain exposure to leverage on the price of an underlying asset.