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'CFD' stands for Contract For Difference. This is a contract to exchange the difference in value of a financial instrument (the underlying market) between the time at which the contract is opened and the time it is closed.
What this means is that with a CFD broker you select the market you want to trade however rather than making the full physical purchase (or sale) you open a CFD with the broker instead. This contract will replicate the profit and loss of your intended purchase (or sale).
CFDs are fast growing in popularity as a flexible alternative to traditional share trading, giving you a greater degree of leverage on your investment capital.
How a CFD works
Let’s say you want to buy 1000 shares in BP. You could buy these shares through a stock broker, paying the full value of these shares (1000 x the current market offer price of BP) plus a commission to the stock broker.
Alternatively, with a CFD broker like InterTrader you could buy 1000 CFDs in BP. To open this trade you would have to supply a margin (deposit) to cover any potential downside.
Selling shares through a CFD broker is easy. You simply open your contract to go short rather than long, you do not need to own the stock in order to sell it. CFDs are often used by investors who want to hedge an existing investment portfolio.
Although they were originally created for share trading, CFDs are also used to trade the stock market indices, forex and commodities markets.
Note that some brokers will charge a brokers’ fee for each new trade, however, with other brokers like InterTrader there is no such fee, the charge is already built into the price quoted by the broker.
A CFD is a flexible investment vehicle. For contracts that don’t have an expiry eg Daily Rolling Contracts, you decide exactly when you want to close your position and realise your profit or loss.
CFD Trading Example - Buying
Let’s assume that you want to buy 1,000 Barclays CFDs and the exchange price stands at 135.7-135.8p. The InterTrader CFD Rolling Daily market for Barclays might be 135.6-135.9, so your CFD position will be opened at the upper price of 135.9p. The full contract value of this position is 1,000 x 135.9p or £1359, but to open the contract you need only put down a margin deposit.
Your minimum margin for this position might be 3% of the full contract value, which is £40.77. The margin required will vary depending on how close you set your stop level to your opening level.
This is a ‘rolling daily’ market so while your position is open you will also be debited or credited for overnight financing and you will receive or pay any dividends should Barclays go ex-dividend.
Suppose a fortnight later Barclays shares have risen steadily and the underlying price now stands at 154.3-154.4p. The CFD price for Barclays might be 154.2-154.5, so you can close your CFD position by selling at the lower price of 154.2p.
Your profit is calculated by subtracting your opening price from your closing price and multiplying this figure by 1000 CFDs, so your P&L:
CFD P&L = (Opening Price – Closing Price) x number of shares
CFD P&L = (154.2p – 135.9p) x 1000 shares
CFD P&L = 18.3p x 1000 shares
CFD P&L = £183
However had the shares started to drop and the price of the market fell to 120.2-120.5p. Then you might choose to close your CFD trade in order to restrict any further losses. If so your P&L:
CFD P&L = (Closing Price - Opening Price) x number of shares
CFD P&L = (120.2p – 135.9p) x 1000 shares
CFD P&L = 15.7p x 1000 shares
CFD P&L = £157
To calculate your net profit you should add or subtract any overnight financing and dividend adjustments.
CFD Trading Example - Selling
Let’s assume that you want to go short of Wall Street (Dow Jones), if so, InterTrader might quote 12463-12465.
This means that you can sell at 12463, the lower end of the quote, or buy at 12465, the higher quote.
One CFD contract on Wall Street is worth $1 per index point. You want to risk $3 per point so you sell three CFD contracts at 12463.
As with all trades your position will have an automatic stop loss order attached. Again with InterTrader, for the Wall Street contract the minimum margin requirement is 50, so the minimum funds required to open this position is $150. There is no commission to pay as the charge is included in the dealing spread.
While your position remains open you will have overnight financing and dividend adjustments applied to your account.
A week later the quote for Wall Street has fallen to 12427-12429 and you decide to take your profits.
You close your position by buying three contracts at the upper price of 12429. Your gross profit is calculated by subtracting your closing price from your opening price and multiplying this figure by $3 per point, so:
CFD P&L = (Opening Price - Closing Price) x number of contracts
CFD P&L = (12463 - 12429) x 3 contracts @ $1 per index point
CFD P&L = (12463 - 12429) x $3 per index point
CFD P&L = 34 points x $3 per point
CFD P&L = $102
However had the US Index started to climb and the price of the market moved up to 12503-12505. Then you might choose to close your CFD trade in order to restrict any further losses. If so your P&L:
CFD P&L = (Opening Price - Closing Price) x number of contracts
CFD P&L = (12463 - 12429) x 3 contracts @ $1 per index point
CFD P&L = (12463 -12505) x $3 per index point
CFD P&L = -42 points x $3 per point
CFD P&L = -$126
Where to Trade CFDs
You can trade CFDs online with:
Contracts for Difference (CFDs), margined forex and financial spread trading are leveraged products and may not be suitable for everyone. Losses can exceed your initial deposit. Please ensure that you fully understand the risks involved and seek independent financial advice where necessary.
CFDs Guide, last edited by F. Lawson, 22-Dec-11.
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Warning: Contracts for Difference (CFDs), margined forex and financial spread trading are leveraged products and may not be suitable for everyone. Losses can exceed your initial deposit. Please ensure that you fully understand the risks involved and seek independent financial advice where necessary.
The contents of this website are for information purposes only and not intended as a recommendation to trade nor does the content constitute investment advice. All reasonable efforts have been made to present accurate information. Neither CFDs-Online.com nor any contributing company or individual accepts any responsibility for any use that may be made of the above or for the correctness or accuracy of the information provided.
* Tax law is subject to change. It can also differ if you pay tax in a jurisdiction other than the UK.
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