An introduction to CFDs (Contracts for Difference), a flexible way to trade stocks, indices and commodities. Tom Hougaard explains how margin works and walks you through trading CFDs in both rising and falling markets.

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INTRO:
Contracts for Difference, also known as CFDs, is an investment instrument that allows traders to participate in price movements of securities, indices and even commodities without taking full ownership of the underlying asset.
CFDs enable traders to realize profits from a falling as well as a rising market due to the ability to trade both sides of the market.
In this chapter we will look into some of the benefits of trading CFDs versus physical stock trading.

Scene 1:
CFDs enable investors to leverage an investment up to 20 times under normal conditions based on equities and on share indices. The ability to leverage the investment is a principle benefit of this product.


Scene 2:
There are a number of reasons why investors choose CFDs over physical shares. In practical terms, investing in stocks through CFDs offers similar profit / loss opportunities as when trading stocks in the traditional manner.

One of those items is leverage. It enables the trader to take positions that are larger than his or hers initial deposit on their account. And thus being able to trade on smaller market movements.


Another benefit is that of short selling, where the investor benefits from falling stock prices.

Short positions may even earn interest, even though index CFDs do no earn interest.

There is no interest to pay when trading CFDs intra-day. As long as they’re closed the same day as they’re opened. And that makes CFDs a very attractive proposition for intra-day traders.



Scene 3: What separates CFD trading from share trading?
1. The CFD trader have no shareholder rights, there is no voting rights, you can’t attend annual or general meetings
2. A CFD has to be closed with the same broker
3. CFDs are traded on margin and you will pay interest to carry a position from one day to the next
4. If you have gone short a CFD, you will receive the interest (except if it carries a negative interest).
5. Short Positions will require you to pay the dividend, but if you have a long CFD position you will receive the dividend – if applicable.


Scene 4a: The essence of CFD Trading are as follows:
1. You are trading at underlying market prices
3. You will pay commission to enter and exit the market
5. You can trade the market long or short
6. Margin is low (10% or less)
7. CFDs are available on stocks, stock indices and commodities.


Principle: buying with the aim of making a profit from a rise in price
Buy low, Sell high




Scene 4b: Example of a Rising Market (going long)
Let’s take a trading example, let’s say you think a given company will rise from £6.10, you buy 1000 CFDs at that price. Assume it rises to £7.00, you sell 1000 CFDs at £7.00 to close the position.
You will then have realized a profit of £900.00, excluding any commissions due.

Scene 4c: Example of a Falling Market (going long)
If you bought 1000 CFDs at £6.10 and the market fell to £5.20 and you sold here, your loss would be = £900, excluding any commissions due.


Scene 4d: Example – Selling (going short)
If you think a given company will fall from £6.10, you sell 1000 CFDs at that price.
Assume it falls to £5.50, you buy 1000 CFDs at £5.50 to close the position
Your profit would be £600.00, excluding any commissions due.

Scene 4e: Example of a Rising Market (going short):
If you sold 1000 CFDs at £6.10 and the market rose to £6.70 and you sold here, your loss would be = £600, excluding any commissions due.

Scene 5: How does margin work?
let’s take a look at how margin works when you are trading CFDs.
Let’s say you buy 1000 CFDs in a given company, thinking that it will rise from £6.10.
The value
If you are buying 1000 CFDs at £6.10 the value of your investment is £6100.00 which is the nominal position.
Your margin requirement for this CFD is 10% of the value of your investment.
We will ask you to deposit at least £610.00 in order to control £6100.00 worth of position. This is the initial margin.

Scene 6a:
Imagine you expect in a given investment price to fall. Initially you bought 1000 shares at £6.10 costing £6100.00. Now the shares are trading at £7.00 and your holding is worth £7000.00
So far we have made £900.00 profit or a ROI of 14.75%

Scene 6b:
Let’s look at which options are available to you.
The first option is that you can simply sell your shares to lock in your profit at £7. You will then crystallize a profit of £900.

But there is another option. And that is to use CFDs to hedge your position. If you go down this route you will sell short 1000 CFDs at £7.
Imagine then that the shares, as you anticipated, goes back down to £6.10 – you will now sit with a profit on your CFD position.

So what you may have lost in unrealized paper profits on your physical position, you will now be compensated by the equivalent profit on your CFD short position.

What if they didn’t decline from £7 to £6.10 but what if they rose to £10. How do we stand on our position then? Well on our physical share we’re long from £6.10 but on our CFD position in the same share we’re now short at £7.00 – when we’re hedging, we are essentially closing the position. Some investors use CFDS to lock in profits on their physical shares without selling them.
You may ask why would they do that. There could be several reasons for this, but one of them might be that they want to defer their tax liability.

CFDs give you the flexibility to speculate in both directions of the market – both long and short. While with physical shares you can only go long.


Scene 8:
-Interest is paid or received on the value of your position at the close of the trading day.
-Libor Interest Rate is used for UK shares
-While for Euro and US products, EURIBOR and Fed Funds rates are used
-We will charge a small premium over and pay a small premium under
-Interest also applies to weekends

Scene 9: CFDs Quick overview:
- When trading CFDs you pay commission
- You are dealing at market price when trading CFDs
- Trading on margin or leverage
- You have the ability to trade either short or long positions
- You will receive or pay dividends if there is a dividend payable


CFDs are a great addition to the arsenal of the private trader and investor. In particular the private investor has opportunities to speculate in many different asset classes and create a balanced portfolio of both long and short positions.