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You Are Here: Home > Stockmarket & Trading > CFD Section > CFD Guide > How do CFDs work
CFDs: What are they - How they work
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 their advantages and disadvantages because CFDs have certain intricacies.

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.

Another area to understand is how they're financed 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 at £1.00 a share you'll have to pay the full £5,000 (plus commissions and other costs, not included in this example for simplicity)
  • But do the same trading using CFDs and you'll only have to put up a cash deposit of between 5% - 20% with the balance being lent to you
  • How much of a deposit depends on the share - for large FTSE 100 stocks it will be nearer 5%, for smaller less liquid stocks up to 20%
  • And whereas lending and borrowing money might sound complex all the workings are done in the background by your broker's back office systems
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 the position at £1.30
CFD - Long position in Vodafone
Buy 10,000 Vodafone shares using CFDs at £1.20
10% cash deposit (refundable) (£1,200)
Commission at 0.2% (to open)
(£24)
Financing (4 days at £2.30 per day)
(£9.20)
10,000 Vodafone shares sold at £1.30 - Profit
£1,000
Commission at 0.2% (to close)
(£26)
TOTAL PROFIT
£940.80
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% - 20% depending on the share and 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 -

  1. To make sure clients trade within their financial means, and
  2. So the broker has a cash cushion to at least cover sudden and unexpected losses

Deposits can be raised during testing markets

Margin is always a factor of potential risk which is why if the markets become extremely volatile, CFD brokers will naturally demanded more security from their clients. A prime example is during the banking crisis from August-November 2008.

So it is possible to enter a trade this week where the brokers requests a 5% deposit and yet when doing a similar trade a week or month later the deposit required is 10%. Of course, the opposite can and does happen when the market volatility calms down.

Finally it is important to realise that CFD margin is very black and white, ie no broker will let you initiate a position if you can't immediately put up the cash. You cannot for example agree to pay the money within a few days. Put simply, no money means no CFD trading.

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.

So what's a good level to pay? Anywhere between 0.1% and 0.2%, any higher and that in my opinion is getting into expensive territory. Also, many brokers have a minimum commission level of £10.

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 Vodafone example above the total deal size was £12,000 with a deposit of £1,200 (10%).
  • £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
  • CFD brokers 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 per day
  • The trade was held over 4 nights and that equates to £9.20 in financing charges
  • Financing charges only relate to positions held overnight so they don't apply for day trading
I think you'll agree the financing of CFDs is not that hard to understand. And again, all the workings are carried out automatically by your broker's back office software. All you will therefore see are the charges appearing on your statement.
A short CFD position - HSBC
  • 'Short' = expecting prices to fall
  • If you're unsure what short selling is and how it works see our short selling guide
  • 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
CFD - Short position example
Sell short 1,000 HSBC shares using CFDs at £6.00
10% cash deposit (£600)
Commission at 0.20% (to open)
(£12)
Financing (14 days at £0.30 per day) - CREDIT
£4.20
1,000 HSBC shares bought back at £5.00 - Profit
£600
Commission at 0.2% (to close)
(£10)
TOTAL PROFIT
£582.20
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.

In the above example £6,000 worth of HSBC 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 received on short trades as no position is held overnight
Current financing charges

At the time of writing, Autumn 2009, the LIBOR rate is around 0.70%. So the current CFD charges will be -

  • Around 2.70% for long positions - LIBOR (0.70%) + 2%
  • Nothing for short positions - If LIBOR is 0.7% and CFD brokers pay LIBOR - 2% for short trades that obviously equates to a negative value of - 1.30%. Obviously no broker will charge you interest to go short so in turn expect to receive no money for a short CFD position
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