The theory of CFD trading is very simple, buy low and sell high, but executing that theory requires some practice.Since most CFDs are traded OTC, you are dealing directly with the broker. Most contract terms can be negotiated since no standard set of terms exist. In reality, however, even though each CFD broker offers its own terms they share several common elements.
Trading CFDs begins with opening a position in a specific asset. No expiry date is needed, although it is important to know that generally positions that exist overnight will be rolled over. This means that each night, at a time specified by the broker, the broker will calculate the profit or loss based on the asset’s value at the end of the trading day. Profit will be credited to your account while losses are debited from your trading account in addition to trading costs. Your open positions will then roll-over to the next day. Various trading costs exist depending on the type of CFD, including finance charges, management fees, commissions, and bid-offer spread.
Remember that CFDs are traded on margin, meaning that the trading account must maintain a minimum percentage specified by the broker. Margins are calculated in real-time and displayed to the trader on the account overview screen or trading platform. If the margin drops below the minimum required level the funds should be replenished quickly or something termed a margin call may be made. A margin call is when the broker, sometimes without informing the client, automatically closes a trader’s open positions.
To better understand CFD transactions, the examples below illustrate various types of CFD trades:
Trading CFD Shares Example
Say, for example, Coca Cola shares are trading at 323.9/324 pence (bid/offer) in the underlying market. The share prices track the underlying market prices, so the CFD price for Coca Cola is 323.9/324p (sell price/buy price). You have reason to believe that Coca Cola share prices will increase over the next few weeks. You would want to buy, say 10,000, CFDs of Coca Cola based on the buy price of 324p.
If the Coca Cola shares rise the following week, you can cash in on your profit by closing the CFD trade. Suppose that week, the buy/sell price for Coca Cola share CFDs is 343.9/344p. You can close the CFD position by selling 10,000 CFDs at 343.9p. CFDs are an agreement between two parties to exchange the difference between the closing price of a contract and the opening price of a contract. The difference in the value of the trade from open to close will net you a profit or a loss. In this example, the underlying market moved 20 pence in the direction you had predicted. The closing value is £34,390 (10,000 x 343.9p) versus the opening value £32,400 (10,000 x 324p), resulting in a profit of £1,990 before commission.
EUR/USD (Forex) Trading Example
The next example illustrates how to trade CFDs based on currencies. Market downturns are not necessarily a bad thing since it is possible to make a profit during falling markets. This is referred to as a short trade and is the opposite of a long trade (where you buy low and sell high). For example, you expect Euro to weaken (euro depreciates) against the Dollar and you decide to sell (go short) 2 CFDs at 1.5020. Assume the euro weakens against the Dollar and when it reaches 1.4860 you decide to cash in on your profits. The new bid-ask price is 1.4857/1.4860 and you buy back 2 CFDs at 1.4860.
You sold at 1.5020 and bought back at 1.4860, a fall of 160 points (or pips), which at 2 CFDs net a profit of £320 (1.5020 – 1.4860 x 2CFDs). If however, the Euro appreciated and rose to 1.5180, you would have posted a £320 loss.
Index Based CFD Trade Example
In the final example, we introduce margin requirements, using an index based CFD trade. Suppose the FTSE100 stock index is at 1098.9 and we think it will decrease. A short position on the index is taken and the brokers bid/offer price is 1098.7/1099.1. To open a position we sell 10 FTSE100 CFDs at bid price, (10 x £1098.7 = £10,987). The margin requirement which is the open position times margin percentage, for the example, suppose the margin requirements 0.5%, then the margin requirement is 10,987 x 0.005 = £54.94.
The next day suppose the FTSE100 dropped by 10 points to 1088.7 bid and 1089.1 offer. To take profit, you would close the position. This means buying back the position at the lower price at 10 x 1089.1, so the profit is the difference between opening position and closing the position (£10,987 – £10,891 = £96.00).
If this was a long position on the FTSE100 index, overnight charges would be deducted from the total balance. Overnight financing is made each night, based on a benchmark rate such as the LIBOR rate + the broker’s margin percentage divided by 365.
Notes:
On average, CFD traders win about 40 to 60 percent of the time. Trading profitably can be done without winning 100 percent of the time. Successful traders work to keep their wins at least twice the size of their losing trades.These are the traders that are careful to leave their profitable positions open and cut their losses short at just the right time.When choosing the type of CFD to buy, your strategy should be no different than with the underlying asset. If you believe the stock, index, currency, commodity, or other financial property will appreciate in value, then this asset would be a good CFD trade. The only difference is your upfront cost will be lower since CFDs trade on margin.Market downturns are not necessarily a bad thing since one has the possibility of making a profit during falling markets. This is referred to as a short trade and is the opposite of a long trade (where you buy low and sell high).
