How Do CFD’s Work?

Introduction 

CFD is short hand for Contract for Difference. A Contract for Difference is a type of financial derivative which allows one to trade a wide range of financial instruments without actually owning the underlying asset. A CFD is classed as a derivative as the price of the instrument is derived from the price of the underlying instrument. CFD’s have become the most popular over-the-counter financial derivative, though CFD’s are off limits to Americans due to certain CTFC and NFA regulations. CFD’s were first developed in the early 1990’s and became quickly popular with hedge funds who were able to cheaply hedge their positions, due to the low margin requirements associated with Contract’s for Difference. It wasn’t until the late 1990’s that CFD’s were first heavily promoted to retail clients. Since then the Contract for Difference has become that the number one way to for individuals to trade the financial markets with a huge proliferation of brokerages fighting for a piece of the pie. 
 
How Does a CFD Work
A Contract for Difference is an open ended contract between two parties based on the underlying price of a particular asset or instrument. The contract stipulates that the seller (typically a brokerage such as eToro or Markets.com) will pay the buyer the difference between the current asset price and the asset price as stipulated in the original contract. However, if the difference between these two values is negative then it is the buyer (typically an individual trader) who has to pay the seller. This may sound terribly complicated but it can be explain better with reference to a number of examples. 
Instrument Price at Opening of Contract Bid (Sell) – Offer (Buy) Spread Number of Contracts (Buy/Sell) Price at Close of Contract Profit/(Loss)
Struggling Supermarket Plc. 11p 10p-12p 100 (Buy) 24p £12
Struggling Supermarket Plc. 11p 10p-12p 100 (Sell) 24p -£14
In the first example our trader, let’s call him Loaded Larry decides that the share price of Struggling Supermarket Plc, is going to rise so Buys a 100 Shares (strictly speaking Contracts, as no physical exchange of asset takes place). In order for Loaded Larry to make a profit the share price must rise above 12p, with 12p being his breakeven point. As you can see when Loaded Larry did eventually decided to close his position Struggling Supermarket’s share price had risen to 24p. Netting Loaded Larry a handsome profit of £12 (0.24-0.12 x 100=£12) the profit being difference between the offer and the close price multiplied by the number of contracts (or shares) traded. 
Our second trader, let’s call him Hapless harry decides instead to sell shares in Struggling Supermarket Plc at the same time as Loaded Larry decides to buy. For Hapless Harry to make a profit the share price must drop below 10p, had the share price dropped to 10p he would have broken even.  However the share price rose to 24p meaning that Harry made a loss of £14 (0.24-0.10×100=14) the difference between the bid price and the closing price when Harry decided to cut his losses multiplied by the number of contracts traded.  

Margin Requirements and Leverage 
In the above examples some who wanted to undertake those particular trades using a traditional stock broker would have at least needed £12 in capital undertake the trade. In fact you may struggle to find a stock broker who would undertake a short sale for a small retail customer, due to the complexity of a physical short sale. However CFD brokerages typically have very low margin requirements which can be as low as say 0.5%. Say the particular brokerage in the above example has a margin requirement of 10%, this would mean that Loaded Larry would only need to have £1.20 of capital in order to open this particular position, giving Larry a leverage ratio 1:10, this means that if he had £1,000 deposited in his account he could trade a volume of instruments typically worth £10,000. Leverage such as this both increases rewards as well as elevating risk, for example Loaded could have theoretically made a profit ten times greater than the amount of money in his account. Whereas Hapless Harry could have theoretically made a loss over ten times as great as the money he had in his account. If a trader racks up a loss bigger than the available capital in their account they will be on the receiving of a margin call where they will be forced to either close the position or deposit more funds into the account in order to keep the position open. It is in this way that a CFD trader can lose more money than he initially deposited.  

Overnight Payments & Costs 
While a Contract for difference is essentially an open ended contract there are certain financing costs that need to be taken into account when holding positions open for longer than one trading day. When holding a long position (a buy position) overnight, you will be charged an overnight fee this is typically calculated using a benchmark rate such as the London Overnight Interbank Rate and the broker margin per cent. These overnight fees can really eat into your profits and are something that CFD traders need to be aware of. However it is not all bad news as often when you hold a short position (a sell position) you will be receive an overnight payment again often calculated in the same way as the overnight fee. However not all brokers work this way with some brokerages charging overnight financing costs regardless of whether your position is short or long.  

Commission 
Occurs in one of three ways, either it is calculated into the spread on offer which is the most transparent way of operating as the client can always see what the costs of opening a trade our. Secondly, it can be charged at a flat rate of say £7 per trade or position opened, this is often the case with brokers who offer direct market access. Finally, commission can be taken as a percentage when closing a trade typically around 0.1% of the total value of the closed position. Again commission is something that traders need to keep an eye and take notice of, as a flat rate of commission will really eat into the profits of anyone who is opening relatively small size trades. How a broker charges your commission may ultimately be a deciding factor in deciding which brokerage to pick, for example someone who is undertaking very big trades they may prefer to pay a flat commission rate than pay 0.1% commission on these trades. With brokerages who calculate commission into spreads you generally end up paying by being offered wider spreads than elsewhere. 

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