Understanding CFD Trading - Part 1

Submitted by George Polizogo... on 18 February, 2006 - 07:46

CFDs are a lucrative vehicle for professional market traders to leverage their short and long positions. We seek to understand.

You may already be a trader or are looking for another way to leverage your trades besides using options and warrants. CFD stands for "Contract For Difference". CFDs are a lucrative vehicle for professional market traders to leverage their short and long positions. CFDs offer gearing, short selling, direct trading on prices – no waiting for execution and finally the system and dealers often offer multiple international markets for traders to work on so there are many opportunities. We have a look at what CFDs are and the mechanics to understand this financial instrument.

A CFD – Contract For Difference, is a derivative – it derives its value from another underlying security. It is a contract between you the trader and the broker or dealer. When you trade with CFDs you do not have to outlay the full capital to be exposed to the underlying stock price movements. Because you don’t outlay the full amount, you trade on margin, only needing to pay 3 to 20 per cent of the actual price of the stock, index or other financial security.

An example of a CFD trade is if you wanted to buy $1000 worth of shares and the margin is 10 per cent, your deposit – or margin to maintain that position at that moment is time is $100. When the market moves to $1100 – profiting you $100; the amount of equity you need to put forward is $110 – which is 10 per cent of $1100. This price action is what is called "marked to market". This marked to market process is usually valued daily at close of business. Because you can buy $1000 worth of shares with only $100, you can potentially load up on your positions and own ten times more than what you can purchase with normal shares. Actually "owning" is an incorrect term, as you never do have any right to purchase the shares as with warrants or options.

The CFD contract is only for the difference – whether in Profit or Loss. The dealer pays you a profit if you terminate the contract by exiting your position. You pay the dealer your Loss amount if you terminate the contract from a losing position. Your profit and loss in CFDs are simply calculated by calculating the difference between opening and closing prices and multiplying by the number of shares in the contract (some people may also refer to one share as one contract so 100 shares would mean you have 100 contracts). The total contract value however, is calculated simply by multiplying the number of contracts with the underlying share price.

As with options and warrants, CFDs expose the trader with increased profits or increased losses. Basically every price movement is magnified as your position is leveraged. There is no expiration date on a CFD compared to similar leveraged instruments: warrants and options.

George Polizogopoulos is a staff writer for MyShareTrading.com, an information hub for traders: forex, shares, derivatives, CFD's. MyShareTrading.com © 2006 All Rights Reserved.

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