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What is a CFD?
A CFD stands for a Contract for Difference. This is a contract which is concluded between two parties (a broker and a trader) regarding the price of an underlying security. Trader is given an opportunity to speculate on the change of a stock price without owning the stock. Speaking simply, you make a bet on the price change without the need to access stock exchanges, buy stocks and pay taxes and huge commissions.
If the trader buys a certain amount of shares and their price rises, the CFD broker is obliged to pay the difference between the initial price and the closing price of the contract multiplied by the amount of stocks in the contract. If the price falls, the trader pays the difference.
Profits can be made from falling markets as well as rising markets.
Advantages of CFD dealing compared to real stock dealing:
- much smaller trading costs and commissions;
- faster implementation of your orders;
- fewer restrictions;
- small minimum deposit to open an account;
- trading leverage.
The CFD trader earns all the benefits of actually purchasing the stock, whilst not having to feel the burden of stamp duty taxes.
Leverage
Leverage is one of the reasons why CFDs are popular among traders. Usual leverage is 10 to 1. It offers you an opportunity to buy or sell 10 times more CFDs than your actual funds allow you to.
For example, with ₤1000 you can buy ₤10 000 worth of Contracts for Difference. In this case your profits as well as losses are also increased 10 times.
This means that you can make several trades a day and profit from smaller moves in the underlying stock prices without holding your positions for months with some stocks to get a decent return.
What is an interest charge on overnight positions?
CFD dealings are based on leverage when you pay only about 10% of the whole value of the contract. Your broker lends you other 90% of the money, but you have to pay a certain interest on that loan which is charged daily. It is calculated by taking the predetermined annual interest rate and dividing it by 365.
Do I receive voting rights with my CFD?
As was said before, you don’t really own any securities. That is why you don’t have voting rights with a CFD.
Dividends
From time to time companies pay dividends to their stockholders. If a trader holds a long CFD on a stock during a dividend payment period, his broker will pay him the amount of money equal to that dividend on the ex-dividend date. And vice versa, if a trader has a short CFD position, he will be charged that sum of dividends. This is made for the purpose of reflecting actual value of a stock in the price of a Contract for Difference.
Limits to the amount of trades
Unlike stock exchange brokers, CFD brokers do not set limits to the amount of trades that you can make daily. This allows traders to make dozens of transactions an hour and at the same time pay low trading fees.
Limiting the risk
Besides classical stop-loss order, which closes the trade on a pre-determined price level, you can use a smaller margin (5 to 1 or 2 to 1) or trade smaller amounts of securities.
Is it necessary to exercise my CFD?
Unlike options (another type of contracts), CFDs must be closed when you want to cut your losses. In case with options you can’t lose more than paid premium. In case with a CFD the more the price changes not in your favour the more money you will lose. That is why it is important to determine the level at which you want to close a Contract for Difference and cut losses.
How are CFD prices determined?
Some CFD providers offer their own prices which differ from actual underlying stocks (usually not more than 15-20 pips). This means that you should take to attention the difference of quotes when watching data of other brokers and making trading decisions.
Other CFD providers deliver identical quotes to the underlying securities. This system is called Direct Market Access (DMA) and is considered to be the most transparent.
Collateral requirements and Mark-To-Market Payments
It is your responsibility to watch your account and ensure you meet all the necessary collateral requirements and Mark-To-Market Payments which are determined by your broker. When the funds of your account are close the critical level, you will be notified via the trading platform, email or other ways depending on your broker’s terms. In the case you have insufficient funds to meet these requirements, trading positions may be closed automatically and you will not be able to trade until additionally funding your account.
Collateral rate mostly depends on such factors as market volatility and liquidity of the underlying security. It ranges between 5% and 40%.
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