This is a valid question for anyone considering adding CFDs to their trading arsenal. Share CFDs not only mirror shares price but come with the additional benefits of leverage and the capacity to go short which means that it is possible to profit from both rising and falling markets while using just a small capital outlay.
If you are considering trading with CFDs instead of directly buying and selling the underlying shares, then you definitely want to know how the profit and loss is worked out, so that you can see how you can utilise them to maximise returns. Everybody tells you that CFDs exactly mimic shares in terms of profit or loss, but there are a couple of charges that you may not recognize.
First, you probably know that one main advantage of CFDs is that they allow you a great deal of leverage. Basically this is like buying shares or other securities on margin, which means you do not pay the full price but effectively borrow from your broker to control the security. With shares you can typically trade on a 50% margin, which means you only need half the cost of the shares. It depends on the underlying security, but with CFDs you can typically trade with from 5 per cent to 10 per cent of the security value in your account. Bear in mind the distinction which is that you never actually own any shares, but just hold the CFD.
Because this is the same as borrowing from your broker, the broker will charge you interest which is calculated on a daily basis, every night.
The other cost is a commission, which may be from 0.1% to 0.25% of the value, and this is charged for each trade, in or out of the position. Depending what you are trading, sometimes no commission is charged, and the broker is paid from the spread between buying and selling prices. Commonly with shares as the underlying instrument, you may be charged 0.1% commission.
These are the two direct costs that affect how much profit or loss you make when you trade CFDs. You can compare these to a commission or flat charge per trade, and sometimes stamp duty, when you trade in actual shares.
There are two techniques that can be used when calculating profit and loss; the exposure and per point method. For both methods let us assume that we buy 1000 VOD CFDs at a price of $10, and sell them the next business day at $10.50.
The best way to illustrate the profit or loss on a share CFD trade is through a worked example. Say you want to buy 1000 VOD CFDs, equivalent to 1000 VOD shares, and they are trading at $10. The total value of the stock interest would be 1000 x $10, which is $10,000. Your cost to trade the CFDs is the commission at 0.1% of $10,000, which is $10.
Say you held them for one night, you would be charged one day’s interest. The rate of interest is usually pegged to a standard such as the LIBOR, and may be +2% on that rate. Assuming this is say 6% per year, then you would be charged 1/365th, which is approximately $1.64.
The next day the shares are trading at $10.50, and you decide to liquidate your CFD position. When you close your position the underlying shares are worth $10,500, and the commission is $10.50, as the value has gone up.
In summary, the costs have been $10 + $1.64 + $10.50 = $22.14. The gross profit is $500 ($10,500-$10,000), so your net profit is $477.86.
Method 1 – Exposure Method |
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DAY 1 | ||||
Opening Purchase Price | $10.00 | |||
Buy Quantity | 1000 | |||
Total Exposure | $10,000 | |||
Commission Paid (0.1% of Exposure) | $10.00 |
DAY 2 | |
Closing Price | $10.50 |
Quantity sold to close position | 1000 |
Position closed | $10,500 |
Commission Paid (0.1% of Exposure) | $10.50 |
Overnight Finance Charge | $1.64 |
Gross Profit | $500 |
Commissions & Finance | $22.14 |
Net Profit (Gross minus commissions & finance) | $477.86 |
In this case to find out the profit and loss using the 'per point method' for the above example, simply divide the number of VOD shares by 100:
1000 VOD shares ÷ 100 = $10 per point (cent) movement.
What this means in practice is that if the stock's price increases by 1c or 1 point, the CFD position will profit by $10 (or vice versa should the price decrease by 1c). This second method is handy to quickly calculate the amount at risk which makes it ideal for working out stop loss levels and limit orders.
Method 2 – 'Per Point' Method |
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Price Movement (from $10 to $10.50) in cents | 50 | |||
Dollars per point (1000 shares/100) | $10.00 | |||
Gross Profit | 500 | |||
Commissions & Finance | $22.14 | |||
Net Profit (Gross minus commissions and finance) | $477.86 |
Note that brokers typically send statements which provide clients with daily summaries of their account equity, available trading resources, open positions, unrealized Profits & Losses, Trades and Realised Profits & Losses.
Note: if the price of VOD shares had fallen by $0.50 the trader would incur a loss of $522.14.