What does Spread mean in CFD trading Complete guide

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An Introduction To CFDs

The contract for difference (CFD) offers European traders and investors an opportunity to profit from price movement without owning the underlying asset. It’s a relatively simple security calculated by the asset’s movement between trade entry and exit, computing only the price change without consideration of the asset’s underlying value.   This is accomplished through a contract between client and broker, and does not utilize any stock, forex, commodity or futures exchange. Trading CFDs offer several major advantages that have increased the instruments’ enormous popularity in the past decade.

How a CFD Works

If a stock has an ask price of $25.26 and the trader buys 100 shares, the cost of the transaction is $2,526 plus commission and fees. This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a CFD broker formerly required just a 5% margin, or $126.30. A CFD trade will show a loss equal to the size of the spread at the time of the transaction so, if the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the breakeven price. You’ll see a 5-cent gain if you owned the stock outright but would have paid a commission and incurred a larger capital outlay.

If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1263 = 3.95% profit. However, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market. In this example, the CFD trader earns an estimated $48 or $48/$126.30 = 38% return on investment. The CFD broker may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn’t include commissions or other fees, putting more money in the CFD trader’s pocket.

The Complete Guide to CFD Trading

Last Updated on August 3, 2020

CFD trading is for retail traders.

You get access to markets usually reserved for institutional traders and you have a wide variety of markets to trade from.

But here’s the thing:

Just because you have more opportunities doesn’t mean you’ll make more money.

Because when it comes to CFD trading, you must open your eyes and know what you’re dealing with.

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So in today’s post, I’m going all in on CFD trading (the good, the bad, and the ugly).

Let’s get started now…

CFD for beginners: What is it and how does it work?

CFD stands for Contract for Difference and it allows you to buy/sell financial instruments without owning the underlying asset.

Instead of buying Apple shares, you can buy the CFD on Apple.

You’re probably wondering:

“Why would I want to do that?”

You’ll discover the benefits of CFD trading later, but first…

To do so, you must have a CFD broker and here’s how they operate…

How a CFD broker works

Most CFD providers are the market maker.

This means they create a market by taking the opposite side of your trade.

You might be thinking:

“Isn’t this unethical?”

It’s just their business model.

Most retail traders buy/sell in small quantities, and it’s not large enough to be traded in the real market.

Thus, a Market Maker (MM) broker fills this demand by creating a synthetic market for smaller traders.

The benefits of CFD trading you’re probably unaware of

Unlike stock trading, CFD offers a number of benefits you can’t get elsewhere.

You can short a stock

Here’s the thing:

It’s difficult to short a stock outright due to regulations.

But with CFD, you can do it easily.

This means you can hedge your positions in bad times and even profit from the market collapse.

You don’t need huge trading capital

CFD is a leveraged instrument.

This means you can control a larger position size with small trading capital.

If a stock requires 10% margin and you have $1000 trading account, you can buy up to $10,000 worth of stock.

Note: Leverage is a double-edged sword. The returns are higher but so is the risk.

You’ve got access to many markets

CFD trading is a convenient one-stop shop for you.

Because you can access markets like…

  • Indices
  • Bonds
  • Agriculture
  • Commodities
  • Precious metals
  • Cryptocurrencies

All these different markets in one trading account.

How cool is that?

But wait, before you get started in CFD trading, you must know the risks that come with it…

CFD trading risks (this is important)

Compared to stocks, CFDs are riskier because it’s a leveraged instrument.

And here’s what you must know:

  • Counterparty risk
  • Risk of losing everything and more
  • Risk of margin top-up
  • Risk of getting stopped out (prematurely)

Counterparty risk

Unlike stocks which are traded on an exchange, CFDs are traded against the broker.

This means if your broker goes under, everything goes along with it.

You don’t get back your money, your stocks, or anything.

Now I don’t want to be a fear monger, but the possibility is there, albeit slim if you know how to find a good broker (more on that later).

Risk of losing everything and more

Your broker is not stupid.

It requires you to put up the margin to cover your potential losses.

However, there are times the market moves too fast and you lose all your capital — and more.

If that happens, you must repay back what you owe to your broker.

Note: This applies not only to CFD trading but to all leveraged products.

Risk of margin top up

You bought $10,000 worth of Crude Oil at a margin of 20%. So, you need at least $2,000 in your CFD account.

But during volatile periods, your broker might raise the margin to 40%.

This means you must inject more capital to hold the $10,000 position.

If not, your position will be closed out partially or fully (to meet the margin requirements).

Risk of getting stopped out (prematurely)

There might be price discrepancy when CFD trading, especially if your broker is a market maker.

The stock exchange might show $100 per share for Apple.

But the CFD broker would show $101 instead.

This means you might get stopped out on trades which wouldn’t be the case if it’s traded on an exchange.

You’ll discover the costs of CFD trading you’re probably not aware of.

The true cost of CFD trading you’re unaware of

These are the costs of CFD trading:

  • Commission
  • Spread
  • Holding costs
  • Market data

Commission

This is a fixed transaction cost that you have to pay for opening and/or closing your trade.

It’s usually a percentage of your trade or a minimum amount of money, perhaps $10 or $20.

Direct Market Access (DMA) CFD brokers tend to charge a slightly higher commission rate than Market Maker (MM) CFD brokers.

Spread

The spread is the difference between the bid and ask price — and that’s a cost.

For example, Apple has an ask price of $100 and a bid price of $99.

This means if you want to buy Apple right now, it cost you $100.

And if you want to sell it right now, you’ll get $99.

That’s a spread of $1 — which is a cost to you.

Pro Tip: Stay away from low liquidity markets as the spread tends to be large.

Holding costs

This is a financing charge to your account for each day you hold a position.

Here’s how it works…

Let’s say you $1,000 in your account and you borrow $9,000 from your broker so you can buy $10,000 worth of stock.

Interest is charged on the $9,000 you borrowed.

And the interest depends on 2 things…

  1. The financing rate
  2. The holding period

If you want to know the exact cost, go check with your CFD broker.

Market data fees

You’re charged a monthly fee for accessing price data (especially for international markets).

But if you trade often, your broker could waive the fee.

How much money do you need to start CFD trading?

I recommend you start with a minimum of $20,000.

Trading fees are about $20 per trade (including buy and sell).

If you think about it…

Your transaction cost is about 0.1% on every trade (20/20,000).

So, if you take 50 trades per year, you’re looking at a total transaction cost of 5% (0.01 * 50) a year.

This means if you want to breakeven, you must earn 5% a year.

And what if your account is smaller than $20,000?

On a $10,000 account, you need 10% to breakeven.

On a $5000 account, you need 20% to breakeven.

On a $2000 account, you need 50% to breakeven.

So if you want to give yourself the best chance of success, you must have a minimum account size of $20,000 (or more).

How to find a reliable CFD broker so can sleep soundly at night

I don’t want to openly recommend any brokers because I’ve no idea what goes on behind the scenes.

And I don’t want you to lose your hard earned money because I recommended the wrong thing.

Still, there are things to consider when choosing a CFD broker:

  1. Is it regulated?
  2. Is the support service good?
  3. Is withdrawal easy?
  4. Does it have the platform you want?
  5. Does it have the markets you want?

And now, the most important question to ask yourself…

Is CFD trading for you?

CFD trading is not for you if…

You’re a long-term investor

Most investors have a holding period of years.

But remember, CFD incurs a holding cost every day, and this eats into your return.

If your CFD trade turns out to be a bummer, you suffer even more losses.

You’re a newbie

CFD is a leveraged instrument and you could lose more than your deposit.

So for new traders, I recommend studying risk management first before anything else.

CFD trading is for you if…

You want to hedge your portfolio

You can take on the opposite side of your trades and thereby reduce the volatility of your portfolio.

You want to take short stocks

Unlike stocks, CFD allows you to short stocks with little to no restriction.

You want to trade a variety of markets

This is useful if you want to trade different types of markets like Futures, Forex, Stocks, etc.

Conclusion

In today’s article, you’ve learned:

  • CFD trading allows you to trade the markets without owning the underlying asset
  • CFD trading allows you to short a stock and access different markets (without huge capital)
  • The cost of CFD trading are commission, spread, holding costs and market data fees
  • I recommend starting a CFD account of least $20,000 with a CFD broker so your commission doesn’t “eat” a huge chunk of your returns
  • CFD trading is not for long-term investors and newbies

Now over to you…

What’s your take on CFD trading?

Leave a comment below and share your thoughts with me.

What is a contract for difference?

A contract for difference (CFD) is a popular form of derivative trading. CFD trading enables you to speculate on the rising or falling prices of fast-moving global financial markets (or instruments) such as shares, indices, commodities, currencies and treasuries.

CFD trading explained

Some of the benefits of CFD trading are that you can trade on margin, and you can go short (sell) if you think prices will go down or go long (buy) if you think prices will rise. CFDs are tax efficient in the UK, meaning there is no stamp duty to pay*. You can also use CFD trades to hedge an existing physical portfolio.

Introduction to CFD trading: how does CFD trading work?

With CFD trading, you don’t buy or sell the underlying asset (for example a physical share, currency pair or commodity). You buy or sell a number of units for a particular instrument depending on whether you think prices will go up or down. We offer CFDs on a wide range of global markets and our CFD instruments includes shares, treasuries, currency pairs, commodities and stock indices such as the UK 100, which aggregates the price movements of all the stocks listed on the FTSE 100.

For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss.

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What is margin and leverage?

CFDs are a leveraged product, which means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’ (or margin requirement). While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the CFD position.

What are the costs of CFD trading?

Spread: When trading CFDs you must pay the spread, which is the difference between the buy and sell price. You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favour before you start to make a profit, or if the price moves against you, a loss. We offer consistently competitive spreads.

Holding costs: at the end of each trading day (at 5pm New York time), any positions open in your account may be subject to a charge called a ‘holding cost’. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate.

Market data fees: to trade or view our price data for share CFDs, you must activate the relevant market data subscription for which a fee will be charged. View our market data fees

Commission (only applicable for shares): you must also pay a separate commission charge when you trade share CFDs. Commission on UK-based shares on our CFD platform starts from 0.10% of the full exposure of the position, and there is a minimum commission charge of £9. View the examples below to see how to calculate commissions on share CFDs.

Please note: CFD trades incur a commission charge when the trade is opened as well as when it is closed. The above calculation can be applied for a closing trade; the only difference is that you use the exit price rather than the entry price.

What instruments can I trade?

When you trade CFDs with us, you can take a position on over 10,000 CFD instruments. Our spreads start from 0.7 points on forex pairs including EUR/USD and AUD/USD. You can also trade the UK 100 and Germany 30 from 1 point and Gold from 0.3 points. See our range of markets

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Example of a CFD trade

Buying a company share in a rising market (going long)

In this example, UK Company ABC is trading at 98 / 100 (where 98pence is the sell price and 100pence is the buy price). The spread is 2.

You think the company’s price is going to go up so you decide to open a long position by buying 10,000 CFDs, or ‘units’ at 100 pence. A separate commission charge of £10 would be applied when you open the trade, as 0.10% of the trade size is £10 (10,000 units x 100p = £10,000 x 0.10%).

Company ABC has a margin rate of 3%, which means you only have to deposit 3% of the total value of the trade as position margin. Therefore, in this example your position margin will be £300 (10,000 units x 100p = £10,000 x 3%).

Remember that if the price moves against you, it’s possible to lose more than your margin of £300, as losses will be based on the full value of the position.

Outcome A: a profitable trade

Let’s assume your prediction was correct and the price rises over the next week to 110 / 112. You decide to close your buy trade by selling at 110 pence (the current sell price). Remember, commission is charged when you exit a trade too, so a charge of £11 would be applied when you close the trade, as 0.10% of the trade size is £11 (10,000 units x 110p = £11,000 x 0.10%).

The price has moved 10 pence in your favour, from 100 pence (the initial buy price or opening price) to 110 pence (the current sell price or closing price). Multiply this by the number of units you bought (10,000) to calculate your profit of £1000, then subtract the total commission charge (£10 at entry + £11 at exit = £21) which results in a total profit of £979.

Outcome B: a losing trade

Unfortunately, your prediction was wrong and the price of Company ABC drops over the next week to 93 / 95. You think the price is likely to continue dropping so, to limit your losses, you decide to sell at 93 pence (the current sell price) to close the trade. As commission is charged when you exit a trade too, a charge of £9.30 would apply, as 0.10% of the trade size is £9.30 (10,000 units x 93p = £9,300 x 0.10%).

The price has moved 7 pence against you, from 100 pence (the initial buy price) to 93 pence (the current sell price). Multiply this by the number of units you bought (10,000) to calculate your loss of £700, plus the total commission charge (£10 at entry + £9.30 at exit = £19.30) which results in a total loss of £719.30.

Short-selling CFDs in a falling market

CFD trading enables you to sell (short) an instrument if you believe it will fall in value, with the aim of profiting from the predicted downward price move. If your prediction turns out to be correct, you can buy the instrument back at a lower price to make a profit. If you are incorrect and the value rises, you will make a loss. This loss can exceed your deposits.

Hedging your physical portfolio with CFD trading

If you have already invested in an existing portfolio of physical shares with another broker and you think they may lose some of their value over the short term, you can hedge your physical shares using CFDs. By short selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio.

For example, say you hold £5000 worth of physical ABC Corp shares in your portfolio; you could hold a short position or short sell the equivalent value of ABC Corp with CFDs. Then, if ABC Corp’s share price falls in the underlying market, the loss in value of your physical share portfolio could potentially be offset by the profit made on your short selling CFD trade. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again.

Using CFDs to hedge physical share portfolios is a popular strategy for many investors, especially in volatile markets.

Attend one of our regular webinars or seminars and improve your CFD trading skills.

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Experience our powerful online platform with pattern recognition scanner, price alerts and module linking.

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