CFD enables traders to speculate on future market price changes of a financial asset, without actually owning or holding the underlying asset.
CFDs are traded over-the-counter (OTC) with a securities firm, known as a CFD broker or CFD provider. CFDs are available for a range of underlying assets, e.g. shares, commodities, and currencies.
A CFD involves two trades:
First, you enter into an opening trade with a CFD broker at a certain price. This creates an open position which you later close out with a reverse trade with the CFD broker at the new price.
If the first trade is a buy for a short or long position, the second trade which closes the open position is a sell when the broker buys back the asset. if the opening trade was a sell or short position, the closing trade would be a buy.
The CFD captures the price arbitrage of the underlying asset between the opening trade and the closing trade.
Where you hold a long position in the CFD:
If closing out price > opening price CFD provider pays you the difference between the opening and closing prices of the CFD
If closing out price < opening price You pay the CFD provider the difference between the opening and closing prices of the CFD
Where you hold a short position in the CFD:
If closing price is less than opening price the CFD broker pays you the difference between the opening and closing out prices of the CFD
If closing price is more than the opening price You pay the CFD broker the difference between the opening and closing out prices of the asset
The proceeds you pay or receive will be subject to commissions or other charges made by the CFD broker
CFDs are leveraged trading instruments; they are traded on margin. Instead of paying the full value of the underlying asset, you pay a fraction which called “initial margin” to open the position and are required to maintain some minimum margin level for open positions at all times. You may be required to repay the margin calls at very short notice, especially in volatile markets. If you fail to top up your margin when required, you risk having your position eliminated at a loss.
What is the return?
The CFD captures the price difference between the underlying asset opening price and the closing-price
Why trade CFDs?
A CFD allows you to speculate on the future market movements of an underlying asset, without actually owning or taking physical delivery of the underlying asset.
As an investor, you pay an initial margin to open the position and are required to maintain some minimum margin level for open positions at all times. You may be required to satisfy the margin calls at very short notice, especially in volatile markets. If you fail to top up your margin when required, you risk having your position settled at a loss.
CFDs are traded on margin. This means you pay a small proportion of the value of the underlying shares (typically between 1% to 30% set by the CFD provider) to open the position, instead of paying the full value for the underlying shares.
Example 1: Initial Margin
Suppose the shares of XYZ are quoted at an offer price of $200.00 and you want to buy 100 shares of XYZ as a CFD at the offer price of $200.00. Assuming the CFD broker sets the margin of the CFD at 1%, the initial margin you put up will be 1% x $200.00 x 100 = $200
You will be able to open the position with $200 versus a payment of $20,000 for the underlying shares.
The leveraging effect means that if the markets move in favor of or against your position, your respective profits or losses will be magnified. Here are some examples of how leverage impacts your profits and losses.
Example 2: Example of a Profit
Suppose on the next day, the shares of XYZ have risen and are quoted at a bid price of $205.00 you then decides to sell his CFD at $205.0. you will-will gain a profit of $500 [($205.00- $200.00) x 100].
The return on investment (ROI) from the CFD works out to 150% (500 ÷ 200). This compares to an ROI of 2.5% if you invested directly in the underlying shares.
CFD positions are subject to Forced liquidations those happen when the trader’s Current Margin drops below the Maintenance Margin
no guarantee can be made that a trader will receive a Margin Call warning in time to prevent a forced liquidation.