How Contracts For Difference Work
Contracts for difference (CFDs) deliver a number of key advantages to traders of all kinds, as we’ve seen at length in the previous section. There’s no doubt that profitable opportunities exist for traders that have the knowledge and skill to make the right trades. But part of that knowledge component comes down to understanding, and how familiar the trader is with the fundamental ideas behind CFDs in practice.
CFDs are theoretically easy in concept, but shouldn’t be underestimated. In fact, CFDs are complex investment products that, although broadly standardised, present a high risk to the trader and a real and ever-present threat of unlimited losses for positions that go wrong. As a result, it’s absolutely vital that you understand what you’re dealing with, and the ins and outs of what makes up a CFD transaction, before starting to make calls and manage your CFD portfolio.
CFDs have a number of unique features that makes them distinct from other instruments. They are margin traded, highly leveraged instruments that are generally (although not exclusively) sold off-exchange across a range of different markets. They can be a fantastic way to capitalise on incremental market movements, but also an extremely dangerous tool for any investor. But getting down to the finer detail is what’s key to truly understanding CFDs – knowledge which can then be interpreted to make profitable trading decisions.
Buying and Selling CFDs
CFDs are similar in some respects to spread betting. In spread betting, you work out your position using your research findings and understanding of a given market, and you open up your trading account and place the transaction. If you’re ‘buying’, you’re supporting the market in the hope that it will rise and you can ‘sell’ your position for a profit – even though no actual transacting takes place. The trade is in fact notional, and nothing more than an agreement with the broker to receive or pay the difference between the opening and closing price. In the same way, a trader can ‘sell’ a market he thinks is going to fall, and still profit equally from a decrease in value by later ‘buying’ the market to have a cancelling effect. The contract stands between the trader and the broker, and it exists in equal scope for transactions on the buy and sell side.
The profit in CFD trading comes from the difference between the buy and sell prices, less any expenditure incurred along the way. Because spread betting is a leveraged product, financing costs are payable on the amount of finance provided by the broker for leveraged positions, and these charges are applied on a daily basis as a percentage that is deducted from your trading account. So, the magic formula then has to be closing sell/buy price – initial buy/sell price – (interest x n days) – transaction costs = profit/loss.
This means, in order to generate a profit from CFDs, you have to find opportunities in markets where the buy price today is less than it will be tomorrow, or where a market is going to drop over the short term. Unlike shares, CFDs don’t deliver a yield, so the only opportunity for making money from CFDs is in the transaction, and the speculation on the movements of price in either direction in whatever market you choose to invest. What then determines these price movements, and how can you begin to identify opportunities in these markets for generating a profitable transaction?
CFDs move in response to market rises and falls. Markets work on the basis of a constant playoff between demand and supply, and the market level rises and falls as a consequence of this equation. When markets look set to rise, they do in fact rise because more investors back the relevant underlying asset or market. If a market looks set to fall, invariably the market will fall because traders will sell off their exposure, and thereby create excess supply which pushes prices down. As a broad assertion, something that it is in-demand will be harder to come by than something that is in plentiful supply, and this creates both an upwards and downwards pressure on prices in different circumstances.
The idea, therefore, is to buy (or sell, if you’re going short) as early as possible before the market gains any momentum in that particular direction. As a broad assertion, you don’t need to be ahead of the market, but just as early as you can be in order to benefit from the biggest swing in price for when you come to sell your position later down the line. Remember – the broader the gap between the initial buy/sell price and the closing price, the greater your return will be. This is true both in straight and leveraged investments, with leveraged investments differing only in the degree of return they provide for traders.
This then provides the basis for calculating your potential returns from a particular transaction – simply by finding the difference between the opening and closing price, multiplied by the size of your order, less the leverage part and any costs you will be expected to repay. Bearing in mind this straightforward, practical formula when making your trading decisions will enable you to better understand whether an opportunity boasts the potential for a profitable return.
Of course, no consideration of the viability of a transaction would be complete without a preliminary understanding of trading on margin, and everything it entails for the trader. Trading on margin is very often the core difference between CFDs and competing instruments, and a solid foundational knowledge of what margin is and how it work is essential to make sure you can competently manage your exposure to risk.