Ins and Outs of CFD Trading
CFDs are a popular form of investment for retail as well as institutional investors. Used with caution, they can be an efficient alternative to traditional forms of trading or as a way to hedge your portfolio. CFDs are not without their pitfalls however, and before trading it is vital to understand the risks involved.
- What are CFDs?
A Contract for Difference (CFD) is a form of financial product that enables you to trade on fluctuations in the price of currency, commodities, shares and indices markets without having to own the underlying asset. Essentially, clients enter into a contract with a broker for one party to pay the difference in value from the time the contract was opened to when the contract was closed.
- What are the main costs of CFD trading?
Commission: Dependent on the currency and market traded, CFD trades are usually subject to a commission levied by the broker.
Holding Costs: Any open positions at the end of a trading day may be liable to a holding cost (or ‘overnight financing fee’).
Spread: This is the difference between the buy and sell price. Because you open the trade at the buy price and close at the sell price, or vice versa, you always pay the spread. The tighter the spread, the less you pay to trade.
- How does a CFD trade work?
In a CFD trade contracts are exchanged. On any market you can choose to ‘go long’ (buy), or ‘go short’ (sell).
For example, the Germany 30 is currently priced with a bid-offer spread of 10,190 – 10,191 (the sell price is 10,190 and the buy price is 10,191, giving a spread of 1 point).
You believe that the market value will rise, so decide to ‘go long’ and buy 10 contracts (units). The size of 1 contract on the Germany 30 is €1, so the trade has a total value of €101,910 (10 x 10,191).
The market rises as predicted and when it reaches a value of 10,200 – 10,201, you decide to close your trade and sell your 10 contracts. The difference between the opening leg and closing leg of your trade is 9 points (10,200 – 10,191 = 9). This gives a profit of €90 (9 x 10).
Even though the market moved by ten points, the one point spread is taken out of the transaction and €10 goes to the broker.
What if the markets fall?
Conversely, if the Germany 30 fell in value and you decided to close your trade at a bid-offer spread of 10,180 – 10,181, the difference between your opening and closing trade would be 11 points (10,191 – 10,180 = 11). This would give a loss of €110. It is worth noting that the broker takes the spread (in this case €10), no matter which way the markets move, whether you gain or lose.
Unlike some traditional forms of trading, CFDs are a leveraged product. Only a margin of the nominal value of the trade needs to be deposited to gain full exposure.
For example, in the Germany 30 trade above there is a margin requirement of 1%. The nominal value of the trade is €101,910. To open the trade you would have to deposit €1019.10.
Margin trading offers far greater exposure to the markets than traditional forms of trading. However, whilst there is a greater opportunity for profit the risk of substantial losses is also increased.
- What are the advantages of CFD trading?
Margin trading: CFD trades allow for a far greater exposure to the market than traditional trading.
Short selling: Because you can ‘go short’ on a market, you can profit when the value of a security is falling. If you ‘go short’ and the market rises, you will incur a loss.
Hedge your portfolio: Short selling CFDs allows you to hedge a traditional long only share portfolio.
UK Stamp Duty: Unlike traditional forms of trading, you never own the underlying asset when you trade CFDs. This means that you don’t have to pay UK Stamp Duty. However, unlike financial spread betting you are liable to pay UK Capital Gains Tax.
Risk Warning: Spread bets and CFD trades are leveraged products. Losses may exceed deposits.