CFD explanation
Trading shares with leverage
What is CFD trading?
A CFD is a Contract For Difference. The contract refers to the agreement between a broker or CFD company and its client, the trader.
It is an agreement to exchange the difference between the price of a share at the opening and the price of a share at the closing of a particular trade. This will either result in a profit or a loss for the trader.
CFDs are traded on margins and, as with Spread Betting, profits can be made from falling markets as well as rising markets because the trader does not actually own the shares.
Trading CFDs on a Margin?
Instead of funding the entire cost of the total number of shares, a trader provides the CFD company with a deposit which is used as a ‘margin’ for the bet. This gives the trader access to a larger amount of shares than would be available to him if he were trading on the live markets.
The idea of trading on a margin is that the trader only pays a percentage of the quoted share price. A CFD company advertises a rate and so the trader is required to have a much smaller amount of money to start off with then if he was trading live on the share market.
This means that as little as 10% of the overall price of the shares is required as an initial payment on the contract. CFDs do not require the investor to purchase the underlying asset; therefore the CFD trader can hold positions much greater than would be possible in standard investment.
There is no fixed expiry date for CFD trading and so a trade is closed when the client feels it is right to collect their profits or to cut their losses if they have started to lose money.
This is calculated based on the value of the live share, rather than from the margin rate. It is debited automatically from the trader's account, at the same time as the initial margin requirement.
In the process of a trade, commission is charged twice, once on the buy price and once on the sell price.
Interest and Dividends
In order to reflect the trading practices of a live market, interest and dividend adjustments are made, where necessary, to the trader’s account by the CFD company.
These adjustments differ depending on whether the trader has decided to go long or if he has decided to short.
For example, when a long CFD position is open, the CFD company debits interest from the account and credits any dividends which may be applicable.
When a short CFD position is open, the trader’s account is credited with interest and debited for dividends.
The interest adjustment calculation occurs each day based on the closing buy price of the share. This total interest payment is usually credited to your account on a weekly basis and is based on LIBOR.
The daily interest calculation is as follows:
Closing price of share that day x number of shares x interest rate ÷ number of days in year.
If the CFD position is open at the time of an ex-dividend date, the dividend will be calculated as follows: Number of shares x net dividend per share.
Interest adjustments are a certainty during the process of the trade, whereas dividend adjustments will only be made if, when trading on equities, the company whose shares are being traded pays out to shareholders from its post-tax profits
How Commission Applies to CFD Trading
This is calculated based on the value of the live share, rather than from the margin rate. It is debited automatically from the trader's account, at the same time as the initial margin requirement.
In the process of a trade, commission is charged twice, once on the buy price and once on the sell price.
So, why trade CFDs rather than buying the physical shares?
Avoid stamp duty: With a CFD, you do not buy or sell the underlying stock, so do not take physical delivery of the stock. This means you can avoid paying stamp duty (under current UK legislation). Every time you buy a share, you have to pay the government 0.5% of the value of the trade.
Margin flexibility: CFDs are traded on margin which means you can take positions in the market 10 times greater than you would with a cash trade and deposit only 10% of the contract value. So, in the above example you would buy £5,000 worth of stock using only £500. This means that, instead of using and risking your total capital o share investments, you only need use 10% (or thereabouts) to achieve the same profit result.
Long or Short: CFDs give you the ability to buy if you are bullish about the market or sell if you feel the market will move downwards with exactly the same potential profit.
Order flexibility: CFDs allow us to place automated orders in the market to buy or sell at a certain price and, if that order is triggered, automatically to set stop loss and profit target orders on the open position.
Other costs: As the Bank is funding up to approx. 90% of the contract value, long positions will attract a funding charge calculated on a spread over LIBOR and short positions will earn interest calculated on a spread under LIBOR.
Dividends
Despite the fact that you do not take physical delivery of the stock, dividends are still paid to you if you hold CFDs in a company. On long positions you will receive 100% of the dividend and on short positions you will pay 100% of the dividend.
Potential Pitfalls of CFD trading
CFDs can be a great tool to profit from the markets, but they have to be treated with respect. If you buy and sell shares with CFDs, you are going to open up the opportunity to leverage your trade size and may then be susceptible to larger profit and loss swings than you are accustomed to with conventional share trading.
That is why ShareHunter and Two Way Markets have firmly established risk controls and trading rules when using CFDs. These avoid the psychological impact of the two most common trading faults when taking leveraged positions which can make many investors close out profitable trades early or run losing trades leading to an overall loss on their account value. Whilst trading using CFDs can be a profitable tool, it is important to think carefully about the potential high risks involved if you choose to use some or all of the leverage available when trading shares with leverage (CFDs).
CFD example
Trade shares with leverage
Example 1 - Long Position (to profit from share price rising)
Following analysis that shows that the price of shares in Company ABC is going to rise.
Sequence of Events:
• the underlying stock is trading at £4.00 per share
• We decide to buy £20,000 worth of CFDs in Company ABC
(£20,000 x £4 = 5000 CFDs)
• We must put down 10% of the value of the trade and therefore use £2000 worth of margin in your trading account
(20,000 x 10% = £2,000)
• Later - price of the underlying stock has risen to £4.50 and we sell the CFDs to realise the profit
this can be calculated as follows:
purchased 5,000 CFDs at £4.00 per share
sold 5,000 CFDs at £4.50 per share
Gross profit on transaction = 50p per share x 5,000 CFDs = £2,500 (i.e a return of +125% on the amount of margin used)
Assuming commissions are the same for a CFD trade and a standard share trade, using a CFD to buy and sell the shares would equate to a saving of £100 in stamp duty.
You will however be required to pay a financing charge for every night that the bank is funding the position.
In this case, the position size is £20,000. Financing costs are calculated as LIBOR + 3.5% / 365 * TOTAL trade value * Number of nights position is held open.
So, assuming LIBOR is 5.75%, the financing costs for the above example are:
5.75% + 3.5% / 365 * £20,000 * 15 days = £76.02.
Compared to a normal stock trade, you have saved £23.98, but have only committed a fraction of the capital required for a stock trade. Furthermore, had you used a conventional account to purchase the shares then your profit would be £2500 or 12.5%; whereas, using the CFD’s you only committed £2000 of your account so your profit represents a 125% return!!
Example 2 Short Position (To profit from share price falling)
Our analysis shows that the price of shares in Company XYZ is going to fall
Sequence of Events:
• the underlying stock is trading at £2.00 per share
• we decide to sell £20,000 worth of CFDs in Company XYZ.
(£20,000 x £2 = 10,000 CFDs)
• You must put down 10% of the value of the trade and therefore we use £2,000 worth of the margin in your account.
(20,000 x 10% = £2,000)
• the price of the underlying stock has risen to £2.25 per share and has hit the stop-loss price that we set for this trade. The position is closed automatically by buying back the stock at the more expensive price
When the position is closed the Gross Loss made by you can be calculated as follows:
sold 10,000 CFDs at £2.00 per share
purchased 10,000 CFDs at £2.25 per share
Gross loss on transaction = 25p per share x 10,000 CFDs = -£2,500***
One thing to note is that when taking a short position, instead of paying a financing amount you will actually receive interest payments each night a position is held open. This can be calculated using the following equation. LIBOR - 2.5% / 365 * Total traded value * Number of nights position is held open.
So assuming LIBOR is 5.75%, the financing costs for the above example are:
5.75% – 2.5% / 365 * £20,000 * 11 days = £19.58 received.
So the net loss is £2,500 - £19.58 = £2,480.42.
***N.B.
For us to have ‘risked’ the £2,500 in the first place your account would have to have been valued at £166,000.at least (we will not risk more that 1.5% of your capital on any one trade.)
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