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Trading Guides - How CFD trading works
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Trading Guides

How CFD trading works

CFDs, or Contract for Differences, are derivatives. This means the price of a CFD is “derived” from an underlying stock, commodity or foreign exchange market - it is not the physical market itself. CFDs enable you to speculate on the direction that the price of a financial instrument (such as a company share, stock index, currency pair or commodity) will move. The further the price moves in the way you predicted then the more money you make. However, you will lose money if the price moves against you.

Leverage

So you don’t actually buy or sell the underlying asset you want to speculate on. Instead you take a view on whether the price offered by a CFD provider, such as Spread Co, will rise or fall. As you don’t have to buy (or sell) the underlying asset, CFD providers allow you to trade on “margin.” What this means in practice is that you only have to put up a small percentage of the value of the underlying asset to control a large amount of it. In other words, you are dealing with leverage. This means your potential profits are magnified, but so are your losses. For this reason, great care must be exercised when trading CFDs. Fortunately, companies like Spread Co offer ways to control your risk through the use of stop losses.

An example

Let’s consider the UK100 (the index of the top 100 UK-based companies by market capitalisation). Spread Co is constantly making a dealing price, or quote, on the “UK100”, based on the underlying index. This quote consists of a bid (selling) price and a slightly higher offer(selling) price. The spread between the two can be as narrow as 1 point, which means that Spread Co’s charge for opening and closing a CFD is one of the lowest available. Let’s assume that you get a dealing quote of 7490.0 to 7491.0 – this means that you can “sell” at 7490.0 or “buy” at 7491.0

Let’s say you think the index will rise, so you “buy” 1 CFD per UK100 point at 7491.0

Now it’s very important to understand exactly what “one point” means, as it varies across different financial instruments. As far as the UK100 is concerned, a point is 1.0, so if you buy the UK100 at 7491.0 and subsequently sell it at 7492.0 (in other words when our price has moved up to 7492.0 – 7493.0), that is a full point. The UK100 is priced in sterling and that means that 1 point on 1 CFD is worth £1.  If you had bought 100 CFDs at 7491.0 and sold them at 7492.0 you would have made £100.

For example, let’s say you bought 1 CFD at 7491.0 and the UK100 rises soon after so that our dealing quote is now 7541.0 - 7542.0.

You decide to close your position by selling 1 CFD at 7541.0 giving you a profit of £50 (7541.0 - 7491.0 x 1 CFD = £50).

One of the other great advantages of CFD trading is that you can speculate on markets (including individual company shares) falling as well. So looking at a similar example, if you originally thought that the UK100 was set to go down in value, you could have sold at 7490.0 - this time for 2 CFDs per point. But let’s say the index moved against you so that our latest quote is 7524.0 - 7525.0. If you wanted to close out your position you would have to buy back your short at the higher end of our quote. If this happened then you would incur a loss of £70 (7525 - 7490 = £35 x 2 CFDs = £70).

Notional Trading Requirement

So you can lose money if your trade goes wrong, or if you experience a market move against you before you are able to close out your position at a profit. For this reason, CFD providers require you to hold a certain amount of money in your account before you can open a trade. This is a deposit called the “Notional Trading Requirement (NTR)” and it varies in size depending on the market. Taking the UK100 as an example, with Spread Co you are required to hold 0.50% of the value of the position on your account in order to make the trade. So, to buy or sell 1 CFD on the UK100 when it stands at, say, 7500, you would need to have £37.50 of unencumbered funds (in other words, money not needed for other positions) in your account. If you were trading 2 CFDs then you would require twice as much (7500 x 0.50% x 2 = £70.00). But it is important to understand that this is the very minimum requirement as markets are constantly fluctuating. Consequently, it is important to have additional unencumbered funds available in the account to cover adverse market movements. If these resources get exhausted through a negative market move, Spread Co would ask you for additional funds (variation margin) to keep the position open.

Risk Management

One of the keys to successful trading is risk management. This involves carefully planning a trade before putting it on and always using a stop loss. A stop loss is an order to close out a trade at a level specified by you. Stops can be used to lock in profits once a trade has moved some way in the right direction, but more often than not they are used to limit losses. After all, it’s important to bear in mind that you are dealing with leverage in fast-moving markets. Sometimes events can occur outside our control and these can lead to a market reaction that we didn’t expect and which can move markets against us. So that’s why it is important to work out a stop-loss level in advance of opening a trade. It shouldn’t be placed at any old level. It should be chosen with consideration of significant technical levels (such as support and resistance) together with careful money management.

So, in the above example, when you bought 1 CDF at 7491.0 you could have simultaneously placed a stop loss at, say, 7461. Then, if the market moved against you, and traded at or below your stop order, your spread bet would have been closed out at 7461. Now there can be occasions where a market is moving quickly and the price “gaps” or jumps above or below your stop-loss, without trading at that specific price. This can also happen when a lot of orders are triggered together, which often happens around large round numbers and significant technical levels.  A “stop-loss” becomes a market order as soon as the stop-loss price is hit or exceeded. This means the trade will be closed at the market price closest to the specified price on a first come, first served basis. Consequently, you may not get out at the level you expected. However, it’s still important to use stops and some traders prefer to take out a “guaranteed stop” where available. For a modest charge a “guaranteed stop” ensures that your stop will always be filled at the level selected by you - never a less advantageous price, no matter how volatile the underlying market.

Disclaimer:

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Tagged: Trading Guides Guide

Category: Trading Guides


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