How CFD trading works

Julie Brownlee, Fsp Invest, 27 Jan. 2015

Tags: cfd, how cfd trading works, cfds, trading cfds, contracts for difference, what is a cfd, trading,

One popular trading tool is contracts for difference or CFDs.

So what are CFDs? And how does trading them work?

Read on to find out…

What is a CFD?

A CFD is a derivative product, just like single stock futures and options.

CFDs are over the counter derivatives. This is because there’s traded through a bank or company providing CFD trading, not through an exchange like single stock futures.

When you trade CFDs, you enter a contract to exchange the difference between the opening and closing price of the contract with the bank or company your trade CFDs through.

The ins and outs of trading CFDs

When you trade CFDs, one CFD equals one underlying share. This is unlike futures where one contract equals 100 underlying shares.

How CFD trading works is once you enter a trade, you pay a daily funding or financing charge for the period of time you have your position open. If you are short (you sell CFDs instead of buying), you receive the daily funding charge.

Let’s have a quick look at how a long CFD trade works…

You decide to buy 100 CFDs on Company ABC at R8. To place the trade, you just need to put down a margin. This is a percentage of your overall exposure, say 10%.

To keep your trade open, you pay the funding charge on a daily basis. This charge uses the SAFEY (the South African futures exchange’s interest on margin rate) and the daily closing value of the shares.

To make their money for facilitating trading, the bank or company you trade through will also add to this rate, usually 2%

So if SAFEY is 5.22% and the bank or CFD trading company adds 2% to this, you’ll pay 7.22%/365 on the value of your CFDs.

If Company ABC closes at R8.30, you’ll pay 16.42c (100 x R8.30 x (7.22%/365)).

If you’re in a short position, you’ll receive the funding amount, which is calculated as above except the market maker’s fee is deducted from SAFEY. So in the case of our example, this would work out at 7.32c.

If you close your position before the market closes, you don’t pay the daily funding charge.

So there you have it, how CFD trading works.

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