CFDs FAQs

What Are CFDs?

Contracts for differences (CFDs) are contracts between investors and financial institutions in which investors
take a position on the future value of an asset. The difference between the open and closing trade prices are cash-
settled. There is no physical delivery of goods or securities; a client and the broker exchange the difference in the
initial price of the trade and its value when the trade is unwound or reversed.

How Do CFDs Work?

A contract for difference (CFD) allows traders to speculate on the future market movements of an underlying asset,
without actually owning or taking physical delivery of the underlying asset. CFDs are available for a range of
underlying assets, such as shares, commodities, and foreign exchange. A CFD involves two trades. The first trade
creates the open position, which is later closed out through a reverse trade with the CFD provider at a different
price.

Example of a CFD Trade

Suppose that a stock has an ask price of $25.26 and the trader buys 100 shares. The cost of the transaction is
$2,526 (plus any 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 requires 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. If the spread is $0.05
cents, the stock needs to gain $0.05 cents for the position to hit the break-even price. While you'll see a $0.05 gain
if you owned the stock outright, you would have also 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 /
$1,263 = 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. Thus, the CFD trader ends up with more money in their pocket.

Another example:
Suppose that a trader wants to buy CFDs for the share price of GlaxoSmithKline. The trader places a £10,000
trade. The current price of GlaxoSmithKline is £23.50. The trader expects that the share price will increase to
£24.80 per share. The bid-offer spread is 23.48-23.50.

The trader will pay a 0.1% commission on opening the position and another 0.1% when the position is closed. For
a long position, the trader will be charged a financing charge overnight (normally the LIBOR interest rate plus
2.5%).

The trader buys 426 contracts at £23.48 per share, so their trading position is £10,002.48. Suppose that the share
price of GlaxoSmithKline increases to £24.80 in 16 days. The initial value of the trade is £10,002.48 but the final
value is £10,564.80.
The trader's profit (before charges and commission) is: £10,564.80 – £10,002.48 = £562.32.

Since the commission is 0.1%, upon opening the position the trader pays £10. Suppose that interest charges are
7.5%, which must be paid on each of the 16 days that the trader holds the position. (426 x £23.48 x 0.075/365 =
£2.06. Since the position is open for 16 days, the total charge is 16 x £2.06 = £32.89.)

When the position is closed, the trader must pay another 0.01% commission fee of £10.

The trader's net profit is equal to profits minus charges: 526.32 (profit) – 10 (commission) – 32.89 (interest) – 10
(commission)= £473.43 (net profit).