What are CFDs?
Contracts for Difference trading has taken the planet by storm within the last decade and has gone from being an institutional product to one that is heavily traded by the retail market and fast challenging traditional shares trading as the product of choice for flexible, cost-efficient trading.
CFDs are a really good instrument to use for trading as they allow you to leverage your returns. Buying shares via a traditional stockbroker entails paying the full purchase price, but using a CFD it is possible to create the same exposure with less cash.
CFDs basically allow you to trade most markets from a 1% to 10% margin. This is similar to borrowing to trade and the effect is to magnify potential gains or losses by a factor of 10 (assuming a 10% margin requirement), since a 2% rise in a share price would be the same as a 20% return on your initial outlay. Also, prices follow the underlying stock very closely, in fact, it is often hard to see a difference. You do not have to pay capital tax but you do have to pay interest on the loan amount. e.g. if you have bought shares worth 100K, the margin is 5K, but you'll have to pay interest per day on the loan. But it doesn't actually work out to be much.
Long and Short Positions
CFDs also allow you hold both 'long' and 'short' positions. The benefit of this is of course that significant gains can be made both on the way up and on the way down giving you the opportunity to profit in a falling stock market.
Using leverage in CFD trading a trader can take on more risk to make a significant gain. Suppose you bought, for example, 10 oz of gold CFDs at $1071.5 each; you would normally have to spend $10, 715 if you were to actually buy the gold. If you were then able to then sell gold at $1100 you would stand to gain $285 which is a return of about 2.65%. However, with Contracts for Difference you can buy 100 contracts of the stock for a 10% margin or just $1071.5. This reduced cost is referred to as the CFD initial margin. If gold rallied in the next few days of trading and you were to sell it at $1100 you would still make a profit of $285, but your return on capital employed is now 26.5%. On the other hand as you might have realised there is also the scope to suffer a significant capital loss if the market moved against your position.
Whatever the size of CFD contract, the profit (or loss) that you make comes directly from the change in value of the underlying instrument/asset.
The margin, or amount you need to buy the contract, may be as little as 3% of the value as CFD trading is standardly executed with leverage. You will be charged interest for every day that you hold the CFD, as if you had borrowed the money from the broker to buy the full quantity. If the price goes down, and you have a long position, you may also receive a margin call, which is an order from your broker to submit funds to cover your losses to date.
Let's suppose you discover that the Gold market has been especially active as speculators keep pushing up the price - you think there is still room for further rises.
The broker's quote for Spot Gold is 952.1-952.6.
You buy 30 Spot Gold CFDs at 952.6.
Points to note:
1. The tick size for Spot Gold is 0.1, so if Gold moves from 952.6 to 953.6, that is equivalent to 10 ticks.
2. The base currency of the underlying Spot Gold market is USA dollars, so USA dollars will be the currency that you will be trading in.
In the next few days, you note that the Gold price has risen further and the broker's quote is now 965.2-965.7. You decide to close your position by selling at 965.2.
This realises a profit of (9652-9526) X your stake of 30 = $3,780.
Note: In this example daily financing costs have not been included for simplicity.
CFDs are leveraged products and carry a high level of risk to your capital as prices may move rapidly against you. It is possible to lose more than your initial investment and you may be required to make further payments. These products may not be suitable for all clients therefore ensure you understand the risks and seek independent advice.