Contracts for Difference (CFDs) are a simple way to trade which allow you to leverage the value of your money. A Contract for Difference is a binding contract that the seller or buyer will pay to the other the difference between the current value of an asset and a future value when the buyer chooses to close the contract. If the value is greater, then the seller of the contract, or broker, pays the buyer; if the value falls, then the buyer must pay more to the seller.
A CFD is a derivative, meaning that it derives its value from the underlying asset, often a share or a market index. As the buyer of a CFD, you never own or have any rights to the asset, it is just used to value the contract.
Long Trading CFDs
‘Going long’ is simply buying a CFD position to profit from a share price increase. So a ‘long position’ is placed if a trader believes the market will rise and is a very common way to trade CFDs. This means that you are hoping and expecting the value of the asset to increase, as outlined in the first paragraph. This is similar to the position you are in if you buy shares, for instance. A trader buys the position first and sells at a later date to close out the trade. The difference between the entry price and the exit price is the profit or loss that is made on the trade. The opposite of this is to ‘go short’ or a ‘short position’, where you can profit from a fall in the value, and that is described in another article.
Trading the long side implies that you have used a buy order as your opening trade or ‘gone long’. This in turn means that you are expecting a rise in price and will use a sell order to close your position.
When you go long with CFDs, you do not need to have enough money to buy the asset you are trading on. The amount of money you need, or the ‘margin’, depends on your broker and what you are trading, and may be 10% for stocks, and even less for other securities. This is how you can leverage the power of your money, as your contract will still profit by the amount that the asset changes in value. In simple terms, if you only put 10% down, and the underlying shares increase in price by 10%, then you have doubled your money.
Here’s an example, where we also include the incidental costs that CFD trading requires. Suppose you think company YZ’s shares which currently stand at 125p are going to increase in value. You would open your long CFD position for, say, 1000 shares. The value of the shares is £1250, but you do not need that much, the CFDs, at 10%, would cost you a deposit of just £125. You would also pay a small commission for the trade.
Ten days later, the shares have risen to 132p each, and you decide to close out your CFD trade. You are charged interest for each day that you hold the CFDs, as you are in effect borrowing the cost of the shares to hold the position. The interest is related to the bank interest rate, and assume for this example that it is £10. You close the position with a profit of 7p per share, and you must pay a trading commission again. Your net profit is 1000 x 7p, less two commissions and the interest, so you would clear £60 overall, giving you about a 50% gain on your stake.
Long CFD Trading Example
Opening a Long (Buy) Trade: Profit
To place a long trade you need to place an order to buy the CFD. Each broker will use a slightly different method to place orders but if you have bought a share before, it will be very easy to adapt to buying CFDs. To trade short, you need to place an order to sell the CFD. The mechanics of placing the order will depend on the CFD provider that you are using.
Opening the position
Say WXY Ltd is quoted in the market at $3.71/3.72. You think the price is due to rise, and decide to buy 10,000 shares as a CFD at $3.72, the offer price giving you a position size of $37,200 (10,000 x 3.72).
The margin requirement (supposing WXY Ltd is an S&P/ASX 20 stock) is just 10%. Therefore $3,720 will be allocated from your account against this trade as initial margin (10,000 shares x $3.72 = $3,720). Remember that if the position moves against you it is possible to lose more than this $3,720 margin. The same outlay with a regular stockbroker would only give you exposure to the performance of 1000 shares.
In this example, commission is charged at 10 basis points (one basis point is 0.01 of a percentage point).
Thus, the commission rate on this transaction is just 0.1% or about $37 (10,000 shares x $3.72 x 0.1%).
You now hold a position of 10,000 WXY Ltd CFDs with a value of $37,200.
Closing the position
A month later WXY Ltd has climbed to $4.06/4.07 in the market and so your prediction that the price would rise has been proven correct. You decide to take your profit.
You sell 10,000 shares at $4.06, the bid price. The commission charge of 10 basis points will also apply to the closure of the trade and this amounts to $41 (10,000 shares x $4.06 x 0.1%).
Your gross profit on the trade is calculated as follows:
Closing level: $4.06
Opening level: $3.72
Gross profit on trade: $0.34 x 10,000 shares = $3,400. After deducting the commission charges ($37 + $41) from the total revenue you realise a profit of $3,322.
Note: To determine the overall profit on the transaction you would also have to take into account the commission you have paid & interest and dividend adjustments.
Opening a Long (Buy) Trade: Loss
XYZ PLC is trading at 776/778. You think the price will rise so you go long and buy 2000 XYZ CFDs at 778p giving you a position size of £15,560. 2000 x 778p = £15,560
The margin requirement for XYZ is 15%. Therefore £2,334 will be allocated from your account against this trade as initial margin requirement to open the trade. £15,560 x 15% = £2,334. Remember that if the stock price moves against you, it is possible to lose more than this £1,760 initial margin.
In this specific CFD example commission is charged at 10 basis points. One basis point is 0.01 of a percentage point. To determine how much commission you would pay, you multiply your position size by the commission charge. Here this is £15.56 (£15,560 x 0.10% = £15.56).
You now hold a position of 2000 XYZ CFDs with a value of £15,560. Later you see that the XYZ’s share price has fallen to 755/757 and that your prediction that the share price would rise is wrong. You chose to close your position and sell at 755p.
As you originally bought at 778p and sold at 755p, XYZ fell by 23pence. 23pence x 2000 CFDs = £460 loss. The commission charge of 10 basis points will also apply to the closure of the trade, equalling £58.80 (755 x 2000 x 0.10% = £15.10).
After adding the commission charges to your loss on the trade your total loss is £490.66