What are CFD s In finance, a contract for difference (CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller). For example, when applied to equities, such a contract is an equity derivative that allows traders to speculate on share price movements, without the need for ownership of the underlying shares.
CFD s continued In effect CFD s are financial derivatives, originally known as Traded Options, that allow traders to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.
How CFD Trading Works? The difference between where a trade is entered and exited is the contract for difference (CFD). A CFD is a tradable instrument that mirrors the movements of the asset underlying it. It allows for profits or losses to be realized when the underlying asset moves in relation to the position taken, but the actual underlying asset is never owned.
How CFD Trading Works Continued Essentially, it is a contract between the client and the broker. Trading CFD s has several major advantages, and these have increased the popularity of the instruments over the last several years.
Example of a Long Trade A long trade is a position that is opened with a buy in the expectation that the share price will rise. Vodacom is currently trading at R127. Investor A believes that Vodacom is going to rise and places a trade to buy 500 shares as a CFD at R127.50. The total value of the contract would be R63 750, but they would only need to make an initial 10% deposit (initial margin) R6 375.00.
Example of a Long Trade Continued A week later Investor A's prediction was correct and Vodacom rise to R127,50 R136.50 and they decide to close their position. By selling 500 Vodacom CFD s at R136,50. The profit on the trade is calculated as follows: Opening Level R127.50 Closing Level R136.50 Difference R 9.00 Profit on trade - (R9.00 x 500) R4 500.00
Share CFD Example: Short Trade A short trade is a position that is opened with a sell transaction in the expectation that the share price will fall. Barclays is currently trading at R155, 00 Investor B believes that Barclays is overvalued and is going to fall and places a trade to SELL 500 shares as a CFD at R154, 50. The total value of the contract would be R77 250, 00. Even though they are selling short, they would only need to make an initial 10% deposit (initial margin) R7 725,00.
Short Trade continued A week later Investor B's prediction was correct and Barclays falls to R154,50 R146,50 and they decide to close their position. By Buying 500 Barclays CFDs at R146,50. The profit on the trade is calculated as follows: Opening Level R 154,50 Closing Level R 146,50 Difference R8 Profit on trade, (R8 x 500) = R4 000
What is a Margin? Rather than pay the full value of a transaction you only need to pay a percentage when opening the position called Initial Margin. The key point is that 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.
Margin continued The margin on all open positions must be maintained at the required level over and above any marked to market profits or losses in order 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.
Advantage of CFD s Contracts For Difference (CFD s) are traded on margin so you can maximise your trading capital. You can profit from falling or rising markets by trading long or short. A single account can give you access to far greater range of financial markets. You can limit & Manage your risk using a Stop Losses and Limit orders. No expiry date: CFDs don t have a set expiry date and interest is charged on a daily basis. The interest rate could differ daily and for different clients.
Advantage of CFD s No Rollover fees: As CFD s do not expire into a physical delivery, no rollover fees are payable. If a trader holds a long CFD on a stock during a dividend payment period, they will receive payment for that dividend on the ex-dividend date, from the brokerage company. If a trader holds a short position on a stock, they will be charged for the dividend on the ex-dividend date. The purpose of these adjustments is to compensate for the effects that dividends have on share price.
Risk of Trading CFD s The geared nature if margin trading markets means that both profits and losses can be magnified and unless you place a stop loss you could incur very large losses if your position moves against you. It is less suited to the long term investor, if you hold a CFD open over a long period of time the costs associated increase and it may be more beneficial to have bought the underlying asset. You have no rights as an investor, including no voting rights.