What are CFDs and how do CFDs work?
What are CFDS and how do CFDs work?
Trading contracts for difference (CFDs) is simply an agreement to exchange the difference in value of a particular financial instrument such as shares, forex, indices and commodities between the time at which the contract is opened and the time at which it is closed. One of the main reasons for CFD trading, is they enable you to speculate on the rising or falling price of the financial instruments.
Trading CFDs unlike a traditional share when you open a position you are not required to pay for the full value of the trade but rather you are required to deposit collateral. This is known as the initial margin, which can be as low as 5% of the purchase price. In recent years there has been a dramatic increase in the use of CFDs and they have in a short space of time become the instrument of choice for short term stock market investors.
Short and Long CFD trading
Trade CFDs in a rising or falling market. CFDs allow you to trade ‘Long’ or ‘Short’. A Long trade is where you ‘Buy’ an asset with the expectation that it will rise, just as you would when buying a normal share. A Short trade is where you ‘Sell’ an asset that you do not own in the expectation that the price will fall and you can buy the asset back at a cheaper price.
CFD Trading on Margin
Rather than pay the full value of a transaction you only need to pay a percentage when opening the position. This is referred to as ‘Initial Margin’. The key point is that the margin allows leverage, so that you can access a larger amount of shares than you would be able to, if buying or selling the shares themselves. The margin on all open positions must be maintained at the required level in order to keep the position open. If a position moves against you and reduces your cash balance so that you are below the required margin level on a particular trade, you will be subject to a ‘Margin Call’ and will have to pay additional money into your account to keep the position open or you may be forced to close your position.
Overnight Financing
Because CFDs are traded on margin, if you hold a position open overnight it will be subject to a finance charge. Long CFD positions are charged interest, Short CFD positions will be paid interest. The rate of interest charged is set at 2.50%** above or below the current LIBOR (London Inter Bank Offered Rate). The interest on each position is calculated daily by applying the applicable interest rate to the daily closing value of the position. The daily closing value is the number of shares multiplied by the closing price. Each day’s interest calculation will be different unless there is no change in the share price.
No Stamp Duty
There is no stamp duty on CFDs as you do not actually buy the underlying share. (Tax laws may change)
Commission
Commission is charged on CFDs just like on an ordinary share trade. The commission is calculated on the total position value not the margin paid.
If you are interested in trading CFDs (Contracts for Difference), you’re in safe hands. Guardian’s CFD Team are knowledgeable and experienced at trading all types of CFDs.
Share CFD example Long Trade
A Long trade is when you Buy a share CFD
Marks and Spencer is trading at 240–240.25p
You believe that Marks and Spencer’s share price is going to rise and place a trade to Buy 5000 shares as a CFD at 240.25p.
The value of the contract would be £12,012.50, but you would only be required to make an initial deposit of 7.5% (Initial Margin of £900.94.
The commission on the trade is £12.01 (£12,012.50 x 0.1%) unlike a traditional share there is no stamp duty payable.
10 days later Marks and Spencer is trading at 270–270.25p
You decide to close your position and take a profit by selling 5000 Marks and Spencer at 270p which equates to £13,500.
The commission on the trade is £13 .50 (£13,500 x 0.1%).
Profit on trade is calculated as follows:
Opening Level 240.25p
Closing Level 270p
Difference 29.75p
Profit on trade £1,487.50 (29.75p x 5000)
Total commission (£2 5 .51) 10 bps
Interest payments (£29.60)
Overall Profit £1432.39
Of course if the market had moved against you, you would have made a loss.
Share CFD example Short Trade
A Short trade is when you Sell a share CFD
Marks and Spencer is trading at 300–300.25p
You believe that Marks and Spencer’s share price is going to fall and place a trade to sell 5000 shares as a CFD at 300p. The value of the contract would be £15,000, but you would only be required to make an initial deposit of 7.5% (Initial Margin) of
£1,125.
The commission on the trade is £15 (£15,000 x 0.5%).
10 days later Marks and Spencer is trading at 280–280.25p
You decide to close your position and take a profit by buying 5000 Marks and Spencer at 280.25p. The commission on the trade is £14.01 (£14,012.50 x 0.1%).
Profit on trade is calculated as follows:
Opening Level 300p
Closing Level 280.25p
Difference 19.75p
Profit on trade £987.50 (19.75p x 5000)
Total commission (£29.01) 10 bps
Interest payments £7.70
Overall Profit £966.19
Of course if the market had moved against you, you would have made a loss.
In this example by being Short M&S, interest payments are credited to your account.