CFD Trading Guide - Revisited

CFDs Revisited - Trading Long, Trading Short, Trading on Margin, Deposit Accounts

This month, we will be providing a brief 'refresher course' on 'Contracts for Difference', or CFDs.

The launch of CFDs completely altered the investment landscape. Where previously you would only invest in shares if you were hoping to make a profit from a rising share price, the advent of CFDs allows you to make a profit even when you are expecting share prices to fall. CFDs also allow you to speculate on a range of other investments, including indices, sectors, currencies and commodities.

However, whilst many investors are already familiar with the nuances of CFD trading, many people are still looking to clarify some of the basics.

What are CFDs?

A CFD is a financial instrument that allows you to speculate on movements in the price of an individual share, a market index, a currency or even a commodity. Literally, a CFD is a 'contract' between you and your broker that allows you make a profit (or loss!), on the 'difference' between the price at which you 'buy' a contract and the price at which you 'sell' it later. Conversely, you might first sell the contract and then buy it back again afterwards.

It is important to note that a CFD is a 'derivative' instrument - you are not buying directly into the underlying share, currency or commodity, but are entering into a financial arrangement with your broker. The price of the CFD will mirror the price of the underlying investment and will rise and fall accordingly. There are a number of other characteristics that distinguish CFDs from direct investments into shares, currencies or commodities:

·          Profit from price falls as well as rises. Remember, you are not actually buying or selling the underlying investment, but just trading the difference between an opening and a closing price – so it is just as easy to make a profit or loss from market falls as market rises.

·          There's currently no UK Stamp Duty to pay on purchases.

Understanding the risk – leverage & trading on margin

Another important concept to understand about CFDs is 'leverage' or 'trading on margin' - CFDs are a leveraged product and this dramatically increases the associated risks.

When you buy shares, you will have to pay out the full value of your investment at the time of the purchase. And when you sell them, you will receive their full value at that point in time.

CFDs are different. You only need to deposit a small percentage of the 'notional value' of the investment at the outset - typically between 5-10% (5% for an Index-based CFD and 10% for an individual share CFD).

For example, if you wanted to trade £20,000 of Vodafone shares you could either:

·          Buy shares on the stock market - pay out £20,000 to buy 16,000 Vodafone shares @ £1.25 per share, or,

·          Buy a CFD through your broker - which would require you to put down just 10% of the 'notional value' of the shares (10% of £20,000). This is known as the Notional Trading Requirement, or NTR, and equates to just £2,000 in this example.

If the value of the Vodafone stock should increase to £1.50 per share, the total value of the investment will increase to £24,000 (16,000 shares x £1.50), representing a £4,000 increase in value (excluding transaction costs).

·          This would represent an impressive 20% return on the stock market investment (£4,000 gross profit on a £20,000 initial investment),

·          And an astonishing 200% return on the CFD trade (£4,000 gross profit on a £2,000 initial deposit).

But it is worth bearing in mind that a 25p drop in the price of the Vodafone shares would result in a £4,000 gross loss - equivalent to a 200% loss on the CFD trade! This is the downside of trading on margin.

Going long, going short: Examples

The combination of being able to 'leverage' your finances and trade in a wide variety of falling markets makes CFD trading an exciting, flexible (and high-risk!) form of investment. Here we illustrate a couple of examples of how this might work in practise.

We have also included 'finance' in these examples - another concept that is peculiar to CFDs.

·          When you buy a CFD on margin, you are effectively putting down a small deposit and 'borrowing' the money necessary for your trade. This loan is termed 'finance'. You will be charged finance for every night that you leave a long trade open.

·          Conversely, when you sell a CFD on margin you will actually get paid for every night that you leave your trade open!

Finance on a long position is charged at LIBOR plus 1.5%, whilst finance on a short position is paid at LIBOR less 2.5%. (LIBOR stands for the London Inter Bank Offered Rate and is the benchmark reference rate for short-term lending - we will assume it is 4.75% in these examples).

Trading Long on the FTSE

If you believe that the short-term prospects for the London FTSE100 index are good and the index will rise, then you might want to 'buy' an investment that will follow the upward performance of this index - you could choose to buy FTSE 100 CFDs.

This means that you are taking a 'long position' - you will make a profit if the FTSE rises, but a loss if it falls.

The market for the FTSE is being quoted at 4,496-4,500

·          The price for buying FTSE CFDs is £4,500

·          Your initial investment is 10 x FTSE CFDs with a notional value of 10 x £4,500 = £45,000

·          You put down an initial margin payment of 5% the notional value - £2.250

·          2 days later, the FTSE closes up at 4,900-4,904 and you sell your CFDs @ £4,900 per CFD.

Trading Short on XYZ plc

You anticipate that the value of your XYZ plc shares are going to fall after they announce their next set of corporate results. So you decide to sell XYZ CFDs and take a 'short' position.

This means that you will make a profit if XYZ plc's share price falls, but will make a loss if it rises.

The market for XYZ shares is being quoted at 825p per share. You decide to sell 1,000 XYZ CFDs.

·          Your initial investment is 1,000 x XYZ CFDs with a notional value of 1,000 x 825p = £8,250

·          You put down an initial margin payment of 10% the notional value - £825

·          3 days later, XYZ shares have posted a good set of results and the price has risen to 850p. You decide to cut your losses, close out the trade and buy back your CFDs.

The CFD deposit account

CFDs offer potential returns that are many times larger than your initial investment - but equally large losses. If you are confident about the risks associated with trading CFDs and are interested in exploring the full range of markets and trading options, then a CFD deposit account might be right for you:

·          A CFD deposit account requires you to fund the account up front before you trade. The amount that you deposit will determine the total amount you can trade. However, if at any time the market moves against you, you will need to make additional payments to cover your losses.

·          With a CFD deposit account you are able to bet on UK, US, and European equities, indices, sectors, currencies and precious metals.

Your investments and any income from CFDs can go down as well as up. Whether you are traing long or trading short, you can quickly lose more than your initial deposit. Please make sure you understand the risks. CFDs may not be suitable for everyone. You might consider limiting your losses by using an optional Guaranteed Stop Loss - available for an additional fee from most brokers.