Below are a series of examples designed to assist you grasp the fundamentals of CFDs.
You open your trading account with $10 000. Your trade size is $10 000 per trade and with your account leveraged by 10:1 you're entitled a maximum of 10 positions at any given time.
Let’s say that you bought CFDs at a price of $5.00.
With a trade size of $10 000 the number of CFDs bought would have been 2000, that is 10000/5.00 = 2000.
So we place our trade and the value of our CFD climbs to $5.50 at which point we decide to close our position.
The difference in asset value is $5.50 - $5.00 = $0.50, which gives as $0.50 profit per CFD of which we have 2000.
This example takes a very simplistic view but shows that CFD trading is based on the margin in price movement of the underlying asset.
CFDs make use of the 'gearing' or 'leverage' principle. This enables investors to increase their percentage return and losses, on investments. You get leverage when you only have to put down a small amount of money to control a much bigger position.
Let's assume that you have chosen a broker that gives you a 100:1 leverage on your trades and you decide to buy currency with your CFDs account. Your strategy is to go long on the US dollar against the Swiss franc, thus profiting on any rise in value of USD against CHF. You execute your trade buying $100,000 USD (selling 124,770 CHK) with an initial margin deposit of $1,000 and at a rate of $1 to 1.2477 francs.
The value of the dollar does in fact increase against the Swiss franc to 1.2497 and you choose to sell your dollars and close out your position.
You originally paid (sold) 124,770 CHF and your position closed at 124,970, which is a profit of 200 CHF or 160.04 USD.
That is a 16% return on investment, which without leveraging would have amounted to less than 1%.
Leveraging works both ways. As easy as it is to increase your ROI, it is to lose your entire investment should the market go against you. It is recommended that you should approach CFDs with caution and ensure that you use a well practiced and proven trading strategy.
CFDs also provide you with the ability to sell the shares you do not physically own. If you perceive a fall in the market value of an instrument then you can choose to short sell. By short selling a CFD, you can benefit from a fall in the share price. This may be confusing at first, but it should be remembered that CFD trading is based on margin and that margins apply to both profit and loss.
You decide to sell short with company ABC plc. You sell 1,000 ABC plc shares at $5 per share.
The price of ABC plc shares takes a downward movement as you predicted and fall to $3 per share. You decide to close your position at this point, profiting from the difference.
Again a simplistic example and there are other contributing factors such as interest, spread and leverage however this example is provided to demonstrate the short selling principle.
For short positions, interest costs are usually paid to you, not charged, so will offset rather than contribute to any costs. This is described further in our example demonstrating interest premiums and transaction costs.
As with all investing deciding the appropriate time to exit a position is just as (if not more) important as determining the best time to enter into your position. One way of reducing the risk of a share price moving significantly against you is to take advantage of the Stop Loss facility offered by CFDs.
A stop loss allows you to set a price which, if reached, will automatically trigger a sell order (for long positions) or buy order (for short positions) to close your current position. A trailing stop is a stop that moves in the direction of our trade and limits any loss.
In this example you buy a CFD share at $4.70. With a trade size of $10,000 the number of CFDs bought would be 10,000/4.70 = 2,128.
We set our stop loss at $4.50 which means that should the price of our investment move downward to or below $4.50 we would exit our trade at a loss of $0.20 per share, thus controlling our loss and minimizing our risks.
Your decision on where to set your Stop Loss or Trailing Stops may perhaps be influenced by certain technical or fundamental criteria and is something to consider incorporating into your trading strategy.
Initial Margin and Usable Margin
In this example you open a $10,000 account with your prefered broker and decide to go long one lot (1,000 shares) on a stock at a price of $9.00 a share. Your broker requires you to deposit a percentage of your trade as a guarantee of your contractual commitment. This is usually 20% of the total contract value, however brokers have discretion to set lower or higher margins according to the track record of the client and the volatility of the underlying share. Your broker has set an Initial Margin for this trade, at 10%.
Should the value of your stock fall below your Usable Margin, you would receive a margin call and your position closed by your broker. Your Initial Margin value is then returned to your account.
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