| If you've dealt on the stockmarket before you should have little trouble in getting to grips with CFDs. However, it is important to take your time to fully understand how they work and also their advantages and disadvantages.
One area to take particular care is with short selling, or the ability to make profits if a share price falls. To get a handle on short selling please read this guide - an introduction to Short Selling.
One of the main areas to understand is financing because a CFD is a margined product and therefore relies on borrowed money. Take for example the normal stockmarket -
- If you call up a stockbroker and buy £5,000 worth of Vodafone you'll have to pay the full £5,000
- But if you use a CFD you will only have to put up a cash deposit of between 5% - 20% (depending on what share) and the balance will be lent to you
- And whereas lending and borrowing money might sound complex all the workings are done in the background and it's easy to understand.
CFD examples
A long CFD position - Vodafone
- 'Long' = buying the market, expecting prices to rise
- You're bullish on Vodafone thinking the stock will move sharply higher over the next week
- On Monday you buy 10,000 shares at £1.20 using CFDs
- The following Friday you sell 10,000 at £1.30
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CFD - Long position in Vodafone
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| Buy 10,000 Vodafone shares using CFDs at £1.20 |
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| 10% cash deposit (refundable) (£1,200) |
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| Commission at 0.2% (to open) |
(£24)
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| Financing (4 days at £2.30 per day) |
(£9.20)
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| 10,000 Vodafone shares sold at £1.30 - Profit |
£1,200
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| Commission at 0.2% (to close) |
(£26)
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TOTAL PROFIT
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£1,140.80
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Explanations
The deposit
CFDs are margined products and a trader will always have to put up a cash deposit. This will be in the range of 5% - 25% depending what the share is and in turn how the markets are behaving (volatile or non-volatile).
For example, in the example above I've probably overstated the deposit needed to fund the Vodafone position. I've used a 10% deposit but Vodafone is such a large, liquid and non-volatile stock that a broker would probably only require a 5% deposit.
Ultimately the deposit is there for two reasons -
- To make sure clients trade within their financial means, and
- So the broker has a cash cushion to at least cover sudden and unexpected losses
Commissions
Commissions in the CFD market are competitive with most brokers using the percentage based model, ie 0.1% - 0.3% of the overall deal size for both buying and selling. Other brokers might offer a flat rate, perhaps £25 per deal regardless of size.
Financing
As indicated above CFDs offer margin which means you don't have to put up the full amount of money to control the asset. In the case above the total deal size was £12,000 with a deposit of £1,200 (10%).
So £12,000 was lent to the client (even though he put up a deposit of £1,200) and he was charged £2.30 a day in interest. The CFD brokers will normally charge 2% + LIBOR (what is LIBOR - Wikipedia link) as their interest rate. In the above example I assumed LIBOR at 5% so the financing rate was 7%.
- £12,000 / 7% = £840
- £840 / 365 days = £2.30
- The broker will therefore charge you £2.30 a day in overnight financing charges
- And as the trade was held for 4 nights that equates to £9.20 in financing charges
- Note, for day trading there is no financing charge as the position is not held overnight
I think you'll agree the financing of CFDs is not that hard to understand. And again, all the workings will be done automatically by your broker's back office software so all you'll see is the charge appear on your statement.
A short CFD position - HSBC
- If you're unsure what short selling is and how it works see our guide
- 'Short' = short selling an instrument, in this case shares, expecting prices to fall
- You are bearish of HSBC and so sell short 1,0000 shares at £6.00 using CFDs
- 2 weeks later you buy the position back at £5.00
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CFD - Short position example
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| Sell short 1,000 HSBC shares using CFDs at £6.00 |
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| 10% cash deposit (£600) |
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| Commission at 0.20% (to open) |
(£12)
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| Financing (14 days at £0.30 per day) - CREDIT |
£4.20
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| 1,000 HSBC shares bought back at £5.00 - Profit |
£600
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| Commission at 0.2% (to close) |
(£10)
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TOTAL PROFIT
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£582.20
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Financing works in reverse with short CFDs - That means you receive interest
Theoretically when you short sell a share you're lending shares to the market and therefore you should be entitled to receive interest. Yes, that can sound complex because you never owned the shares in the first place but understanding the inner workings of how the financing of short CFDs works won't help you make any more money, nor lose less.
My advice is simple, don't worry about what goes on behind the scenes, just focus on the important point - if you use CFDs to short sell the market you get paid interest.
So in the above example £6,000 worth of stock was shorted and CFD brokers will normally pay LIBOR - 2%. I have assumed that LIBOR is 5% and therefore you'd receive interest at 3% (5% - 2%).
- £6,000 / 3% = £180
- £180 / 365 days = £0.49
- The broker will therefore pay you £0.49 a day in overnight financing charges
- And as the trade was held open for 14 nights that equates to £6.86
- Note, for day trading no interest is paid as the position is not held overnight
Current financing charges
At the time of writing, June 2009, the LIBOR rate is around 1.40%.
This obviously means that for long CFDs the financing charge will be around 3.4% (LIBOR + 2%). But for short positions there would be little if any interest received as LIBOR - 2% would equate to a negative figure.
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Stockmarket/Trading Providers
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Who Owns The Shares In A CFD Transaction?
If you buy 1,000 shares of Vodafone using a traditional stockbroker (not CFDs) you will own the shares, there's no argument.
But trade the same position using CFDs and you don't own the shares, the CFD broker does. In effect you have entered a swap transaction. The broker holds the shares and you hold a piece of paper, the CFD, which gives you 100% of the profits should the shares rise and obviously 100% of the losses should they fall.
A CFD trader is all about the profits and losses so it doesn't matter who owns the physical shares, just that the profits and losses are paid out accordingly.
One thing to note, as you don't own the shares you won't be able to vote in company AGMs etc. But again, this should be of little worry to the CFD trader.
CFDs & Margin
In the above example we covered deposit margin, usually between 5% and 25% of the value of the underlying shares. But all margined products use 2 types of margin -
- Deposit margin, sometimes called initial margin, and
- Variation margin, sometimes called mark-to-market-margin
Variation Margin - What is it - How it works
CFDs as you know are different from buying shares in the stockmarket. If you buy 1,000 shares of ABC Engineering for £1 a share, hold the position for 3 months before selling out at £2, the profit will obviously be £1,000. But this is the point - you can't get your hands on the profit until the shares are sold.
Margined products work differently because all profits and losses are credited and debited from an account in real-time and this is called maintenance margin. For example -
- You buy 1,000 Barclays shares at £1.00 using CFDs
- The market moves sharply higher and you sell them 5 weeks later at £2
- Within this 5 week time period you'll be credited the daily profits and debited the daily losses
- So although the total trades makes a profit of £1,000 this is credited over a period of time - look at the table below to see this in action
Note, that although the trade is open for a total of 5 weeks I have only indicated the first 5 days of trading to show how variation margin works from day to day.
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Day 1
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Day 2
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Day 3
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Day 4
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Day 5
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| Barclay's stock price |
£1.05
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£1.00
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£0.95
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£1.06
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£1.12
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| Maintenance margin (daily) |
£50
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(£50)
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(£50)
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£110
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£60
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| Maintenance margin (running total) |
£50
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£0
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(£50)
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£60
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£120
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Another example - Maintenance margin over 2 days
- Today you buy 1,000 shares of XYZ Industries at £3.00 using CFDs
- Tonight they close at £3.25 and so your account would be credited with positive maintenance margin of £250 (1,000 x £0.25)
- However, the share price reverses the following day and you sell out at £3.00, the price where you initially bought the shares
- £250 in negative maintenance margin will be debited from your account
- So although the trade was a scratch trade (zero profit/loss) it looked like you made a profit of £250 one day and then lost £250 the next - that's maintenance margin at work
- Note - in this example I haven't considered commissions or financing charges
The reason maintenance margin is so important is because of the leverage. Without it a trade could go horribly wrong and the trader might not be able to pay the loss. But if the losses are accounted for every day they cannot usually get out of hand.
One final point - If you can't pay any margin owed by the end of the day your broker has the right to take over your position(s) and dump them.
CFDs & Dividends
I mentioned above that when CFDs are used to buy shares you're not actually buying the physical shares. Rather you're buying a contract, the CFD, that will give you 100% of the profits and the losses.
But this doesn't mean you won't be entitled to any dividends. The broker will pass these on either in full or as some do, 90% of the value. Any dividend payment will be a straight cash credit to your account.
Short CFDs and dividends
But what if you're short a share, how are the dividends handled?
In this case you will have to pay the dividend in full and it will be debited in cash from your account. Some traders new to CFDs immediately think this is a negative but when you look at the workings it doesn't really matter that much.
- When a share goes ex-dividend its price will normally fall by the amount of the dividend payment
- So if a share is priced at £5.00 and goes ex-dividend today (dividend is £0.10) the price should immediately drop to £4.90
- The short seller will therefore have to pay out the £0.10 dividend payment but this will be covered by the share price dropping around £0.10
- One is a loss, the other is a profit, but they cancel each other out
When it pays to use shares over CFDs
Can CFDs be used for investment purposes, ie holding a share for many months? Yes, theoretically a CFD can be held for years but because of the financing charges it's not recommended.
As a general rule of thumb if you hold a CFD for more than 4-6 weeks the financing charges start to get expensive. Ultimately CFDs are designed for traders, and not buy and hold investors. Therefore if you want to hold a share for many months it's often cheaper to buy the physical shares.
However, this does depend on what the share does. If you believe it's got the potential to rise 10%, 20% or even higher over a month or 2 yes the financing can get expensive but this will be more than covered via the profits on the CFD.
Short CFDs however pay interest so financing is not an issue. This means shorts can be held for many weeks or even months without being expensive.
Order types
For a guide to all the different enter, exit and stop orders that can be used with CFDs see these following 2 guides on our Spread Betting section. Note, that orders work in exactly the same fashion whether you're trading stocks, CFDs, options, futures or Spread bets -
Available Markets for CFDs
CFDs are available to trade on all the major shares on all the major European stockmarkets and bourses including the UK, Germany, Spain, Italy, Holland, France, Sweden etc. All the big US shares can also be traded via CFDs.
But what about smaller shares?
Perhaps you're interested in a UK company that has a market capitalisation of £100million. Most CFD brokers will offer their clients a market on any share as long as it has decent daily volume although both the financing rates and initial margins might be set at a higher level.
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