Contract for Difference (CFD) Trading

Back to main Platform page

All Institute traders trade on Contract for Difference (CFD).

What is a Contract for Difference (CFD) and How Does it Work?

A Contract for Difference (CFD) is a contract that you enter with the broker. Let's use a typical example. Let's say you want to buy 10,000 shares in Vodafone Stock at £1.70

Your first choice would be to buy the Physical Shares of Vodafone. The notional amount of this trade is 10,000 X £1.70 = £17,000. If you bought the Physical Shares you would pay Stamp Duty of 0.5%. This would then be rounded to the nearest £5. You would therefore pay £17,000 X 0.005 = £85. Let's assume you also pay 0.25% commission to your broker to buy and 0.25% commission to sell. This means you have also just paid £17,000 X 0.0025 = £42.50 in commission to buy. You will also pay 0.25% on the notional value when you come to sell. You have therefore paid in total £85 + £42.50 = £127.50, to put this position on. In % terms this is 0.75%.You have bought the physical stock, therefore you will receive dividends which you can take or re-invest and you will receive a vote at the Annual General Meeting of the company. You will even receive a nice share certificate stating that you are a Vodafone shareholder. You can hang this certificate on your wall and feel very proud. On any profits from this transaction you will pay U.K. Capital Gains Tax (CGT).

Another choice you would have, would be to buy the Vodafone position on a Contract For Difference (CFD). Instead of buying the physical share through a broker, the broker will write you a contract that mirrors the price of Vodafone one for one in 10,000 shares, with an entry price of £1.70. The price of this contract is derived therefore from the underlying asset i.e. the real physical stock of Vodafone. This is why the contract is a called a "Derivative." The notional value of the contract is the same as if you traded in physical shares i.e. £17,000. If Vodafone stock goes up to £1.87 it means the stock has rallied 10% or 17p. This means the notional value of the contract has increased by 10% also. Therefore the new notional value of the contract is £17,000 X 1.10 = £18,700 - The "Difference" in value of the contract, from when you entered the position with the broker is £1,700 - This Difference is then paid into your trading account by the broker. You may not have even closed your position at this point. This is called "A Mark to Market Profit and Loss" - The broker will take the closing price of Vodafone each day and pay the "Difference" into your account if you are making money, and you pay the broker if you are losing money on the position. The reason the contract is called a "Contract for Difference" is for this very reason.

Typically, when you enter a position, the broker will "Hedge" their position by trading the underlying position in the market. So in this example, the broker would sell you the contract at a notional value of £17,000 with an entry price of £1.70. The broker will then go into the underlying physical market and buy Vodafone physical stock in order to "Hedge" their position to the contract. Regardless of whether Vodafone goes up or down, the broker is now in a position in which they will not lose. If the broker chooses not to Hedge, then they are implicitly "Short" the underlying stock, in this case Vodafone. If the stock does go up, the broker will be losing the equal and opposite amount to which you are making and vice versa if the underlying stock goes down. In the vast majority of cases, brokers do not like this risk and they simply hedge it out.

In terms of the costs of trading, you will pay no Stamp Duty (Tax) when purchasing a Contract for Difference (CFD). For commission rates, you will pay an Execution Only rate or Advisory Rate. Typically an Execution Only rate is 0.1% or 10 basis points. You will pay this if you are not receiving advice from a broker. On this trade in the example we are using, this would be £17,000 X 0.001 = £17. Typically an Advisory rate will vary from 0.25% to 0.5% or 25 to 50 basis points. You will only pay this rate if you are receiving advice from your broker on what they think, you should be buying and selling i.e. trading. On this trade in the example we are using, this would be £17,000 X 0.0025 or £42.50, or £17,000 X 0.005 or £85. One basis point is 1/100th of 1%. Therefore 100 basis points is 1%.

Tax Liabilities when Trading on CFD.

You may or not be subject to Capital Gains Tax on profits from trading on CFD depending on your individual circumstances. If you are subject to U.K. CGT when trading CFD's, any losses you incur can be offset against future profits from CFD trading. In the Vodafone example, when trading on CFD, you will also receive any dividends paid by the underlying asset i.e. the Vodafone dividend. The broker will adjust the price of the contract (in your live trading account), by the equivalent amount of the dividend on the day the dividend is paid known as the "Ex Dividend Date." The price will be changed by an amount to reflect the size of the Dividend. This adjustment will be made in your favour so it is the same as receiving the full dividend. 

Shorting

One of the main advantages of trading on CFD is having the ability to "Short" the contract or take advantage of the underlying price of the asset falling. "Shorting" on CFD simply means the opposite of the example we used above in Vodafone. Instead of buying the contract from the broker, the broker buys the contract from you. So you are selling "Short" the underlying asset to the broker who will be implicitly Long. If the price of the asset then falls you will make money and the "Difference" will be paid into your trading account on a "Marked to Market" basis (based on the closing price of the underlying asset) each day. If the underlying asset goes up, you will lose money and the broker takes the "Difference" out of your trading account each day. Trading short can be more dangerous than trading long. If you buy something (anything), the most you can lose is 100% of the notional value of the position because it means the underlying asset has gone to Zero. If you trade short, theoretically you can lose an infinite amount of money. The asset could go to infinity! Be careful when shorting on CFD or when utilizing any "vehicle" that allows you to short. You can expect to learn a whole lot more than this on our Educational Trading Programme. To be redirected to this area of the website click HERE. In terms of dividends, when you are short a CFD contract, you will also be what is termed "Short the Dividend" - When the company pays its dividend on the ex Dividend Date, The price of the contract will be changed (in your live trading account), to reflect the amount of the Dividend in favour of the Broker. You will be paying out the amount of the Dividend.

Trading on Margin 

When trading on Contract for Difference (CFD), you will be utilising what is termed as "Margin." The broker will typically allow you to trade up to 10 times your initial deposit in Large Cap Stocks, Indices, Commodities and Bonds. On FOREX they will lend you typically up to 100 times your initial deposit. Your initial deposit is known as your "Initial Margin." 

Let's go back to our Vodafone example. Remember the notional amount of this trade was £17,000. Let's say now that you deposit only £10,000 in your trading account? How is it possible that you can participate in this £17,000 position? Well, the broker in this example will typically allow you to borrow up to ten times the amount you deposit on account to trade in Large Cap stocks. For the Vodafone position, this simply means you will be using a portion of your £10,000 on account as collateral against this position. If the broker lends 10 times for Vodafone, then when you enter the trade, you will be "utilising" £1,700 of your initial deposit i.e. 10% of your Initial Margin to this trade. The other £8,300 that is not utilised for Margin Trading can now be utilised to participate in additional trades. If in this example, the price of Vodafone goes in your favour by 10% i.e. the underlying stock goes to £1.87, you will receive an additional £1,700 on a "Marked to Market" basis in your trading account. The new value of your trading account will be £11,700 - However if you lose 10% i.e. the underlying stock price of Vodafone goes to £1.53, the broker will take away £1,700 from your trading account leaving you with £8,300 available to trade on Margin with. This is what we mean when we say that your initial deposit is used as collateral in your trading account to enable you to trade on Margin with. The £10,000 initial deposit (Margin), is used to cover any losses you may incur when trading on Margin.

The amount you pay to cover your losses on a daily basis is called your "Variable Margin." Now let's assume in this example that Vodafone goes to zero i.e. the underlying Vodafone stock price goes to Zero. This means you will owe the broker £17,000 - You will get what is known in the industry as a "Margin Call" - Why is it termed in this way? It is because the Broker will literally send you an email and pick up the telephone and Call you to deposit more money into your trading account to cover the loss. Infact, in reality if Vodafone fell by 59% the value of your account would be zero. This is because you have taken a £17,000 position and deposited only £10,000 in your account as collateral to cover any losses. £10,000 is 59% of £17,000. Therefore if Vodafone fell by 59% i.e. the value of your Contract falls by 59%, your initial deposit would be wiped out and you would receive a "Margin Call" to deposit more money in your trading account to cover any further losses. If you cant stump up the cash, then the broker will trade out of the position on your behalf and crystallise the loss. In this instance you would be wiped out. 

It may seem a little farfetched that a large cap stock like Vodafone could fall by 59% in value. You would be right. It is farfetched. But you are missing the point here. What usually occurs when Retail Traders are trading on Margin is that they will utilise all of the leverage they are offered by brokers. This can be across one position or many positions. Now let's assume the Vodafone position is a £100,000 position. You would be utilizing the entire £10,000 of your Margin collateral to take this position. If Vodafone now fell by 10%, you would receive a Margin call. That's not so unrealistic. Retail Traders make this mistake all the time. They think that just because the broker offers them ten times what they have deposited on Margin, they have to utilise it all. This is not the case. Imagine if you did this in FOREX and leveraged 100 times! Your exposure would be £1,000,000. If the currency pair moved against you by 1% in one day, you could be wiped out in one day! This is not just the case in trading on CFD, but also the case in Spread Betting as well.

Exposure, Position Sizing and Risk Management is always one of the main focuses of a Professional Trader. Professional Traders do not expose themselves to these types of situations. Retail Traders typically do not understand why they are taking a position in something, what their real exposure is, what a sensible position size is in terms of utilising leverage efficiently and when they have a position, and also how to manage their risk effectively when things go right for them and wrong for them. Remember, trading on Margin can result in significant gains AND losses and you can lose all of your initial deposit AND more if you do not know what you are doing. This is why it is essential to understand how to trade properly instead of being taught by someone who has never traded before, doesn't trade themselves and has a conflict of interest to your long term profitability.

You will learn HOW to trade properly and effectively for long term consistent profit using CFD's on our Educational Trading Programme. If you would like to know more about this then please go to the section on this website entitled "Trading and Portfolio Management Education." Or if you would like to be redirected to this area of the website, please click HERE.

Click here to go to the NEXT PAGE - "Trading on Margin"

 

CFDs are a leveraged product and can result in losses that exceed your initial deposit. Trading CFDs may not be suitable for everyone, so please ensure that you fully understand the risks involved.

 

Trader Development

Find out more