CFD stands for contract for difference, where you profit from the change in value of the underlying financial security, such as a stock, without ever owning it. As a derivative, you only pay a fraction of the cost of the underlying, which means you are effectively borrowing money and must pay interest on the value. This is just one of the costs of CFD trading, and you need to understand where the money is going so that you can trade profitably.
First, you may pay commission for each trade, and this can be 0.1% or 0.2% of the underlying value. This is charged both for taking the position and for liquidating it, or ‘in and out’. Some CFD providers do not charge commission, and usually these are market makers who will set their own prices. You will find that you pay anyway via the larger spread that is quoted in these cases. The spread is the difference between the price you can buy at, and what you can sell at. For instance, at Ayondo traders pay 0.1% per cent of the trade on the way in and out.
When you hold a CFD position overnight, you are charged interest as mentioned in the first paragraph above. The interest rate is set as a margin over a published rate, such as the London Interbank Offered Rate (LIBOR), and you’ll commonly see about 2 to 3% as the financing rate. Interest is calculated daily, including weekends, and is based on the current value of the underlying. Note that the amount you deposit to take out the trade, the initial margin, does not offset the value of the borrowing; you pay interest on the total value of the underlying. So for example, if you were to take a long trade for a value of $5,000, it would work out at about $0.92 a day, based on an interest rate of around 6.7 per cent. The amount you pay in interest also depends on what your position is at the end of the trading day. If it’s value is less, you pay less, if it’s worth more, you pay more.
If you take a short position, then you will receive interest if you hold it overnight. The interest is paid at the published rate less a certain margin, for example LIBOR minus 2%. Again the interest is calculated daily, including weekends.
Another cost which you may have, depending on your broker, is a charge for the trading platform and/or data fees, and these would normally be monthly payments. Sometimes these payments are waived if you maintain a certain level of activity on your account. There is also an additional premium if you take on a guaranteed stop-loss option – at IG Markets this would cost 0.3 per cent.
An occasional charge or benefit that you may come across when trading CFDs is the dividend. Although CFDs do not give you any ownership of the underlying shares, if you are long on a share CFD when a dividend is due you will receive a cash payment, slightly less than the dividend amount. The opposite applies if you have a short CFD position in equities. You will find that the cost of the dividend is charged to your account on the ex-dividend date. Note that these payments and charges are not made by the underlying company, but by the provider.
When you go long on a CFD trade you are eligible to receive all the dividends that are paid. The costs for going short are reversed – investors receive interest and they have to pay the dividend.
Finally, there may be ongoing costs while you hold a CFD position. CFDs are marked to market each day, which means that the value is updated in your account. If the position is initially losing, then a variation margin will be deducted from your account, and if the position continues to lose you may be faced with a margin call, which means you must put more money in your account as a matter of urgency. The opposite is also true; if your position is making a profit, then your account will be credited on an ongoing basis.
How To Calculate Transaction Costs In CFD Trading
>The costs of CFD trading may be divided up into these components:
This may be a percentage of trade size eg 0.2% or a minimum commission eg $20, each way for trade sizes below a certain amount. Some providers have no commission.
However, their spreads are not the underlying stock prices, but are instead widened (see below).
With DMA CFDs, the prices reflect the underlying market. However the commissions may be different, so check with each CFD provider the details of their market made CFDs and compare it to their DMA CFDs if available.
2. Spread widening
Instead of using the exact underlying share prices for their CFDs, some brokers use a “market made” price with a widening of the spread.
With some brokers, the exact amount of widening is disclosed eg 0.05% but this may differ depending on the market movements and differ between providers.
In contrast with DMA CFDs, the prices reflect the underlying market and an order is placed in the underlying market.
3. Interest costs
For long positions of CFDs that are held overnight, there is an interest charge. For a short CFD position, the interest is paid to you. The interest rate that applies to long positions is usually the base rate plus a certain %, and that for short positions is the base rate minus a certain %.
For example, the interest may be the LIBOR (London Inter-Bank Offered Rate) +/- 2.5%.
To calculate the interest charge for one day, the formula is:
Interest charge for long position = (interest expressed as a fraction) x (1/365) x (position size).
So for a position with a market value of $10 000, and the LIBOR being 5% (hence interest rate being 7.5% or 0.075), then the cost for this particular day would be:
Interest charge for long position = (0.075) x (1/365) x (10 000) = $2.05.
This is the difference between your intended exit price price and your actual exit price. You may experience slippage depending on the way stop losses are executed by the market maker, the liquidity in the share CFD that you’re trading, and the volatility in the market.
It is a good idea to watch the amount of slippage to make sure that it is not excessive.
If it occurs then check that the stocks that you are trading are not too illiquid or have a low turnover, which may be a cause of the slippage. On the other hand, slippage may be caused by gapping in the prices overnight, known as ‘overnight’ risk.
5. Other fees eg data fees
For some providers, there are monthly data fees, or platform fees as well as the above costs. Some of these fees are lowered or nil if you trade more than a certain number of trades per month.
Note that for some brokers, that the costs, such as commissions and spread widening may be negotiable, or they may be lower if you belong to an educational CFD trading group.
So keep these points in mind when choosing a CFD provider.