Introduction to the Financial Markets

6 Lessons
6 Hours

Introduction to CFDs

Welcome to Introduction to CFDs! In this video, you will learn what CFDs are, the types of CFDs, the advantages and disadvantages of CFDs, and some examples of CFDs.

Contracts For Differences (CFDs)

Contracts for differences, also known as CFDs, are financial derivatives that allow investors to participate in the movement of asset prices without full ownership of the asset. CFDs are over-the-counter financial derivatives that are traded through a dealer network, and not through a formal exchange

CFDs simulate the value of the underlying asset which can be a currency, share, stock market index, or commodity. For example, when you buy one CFD of Microsoft, it is like buying 1 share of Microsoft. The only difference that you don’t own the share. All profit and loss is paid in cash and is determined by the difference between the purchase price and the selling price of the CFD.

Example

Let’s compare XYZ share to XYZ’s share CFD. Starting with the XYZ share.

On the 17th of November, we bought 1000 shares of XYZ at 10 dollars. The value of our position is 10x1000 which is equal to 10000 dollars. On the same day, we closed the trade at 11 dollars. The value of the position became 11x1000 which is equal to 11000 dollars. Total profit for the trade 1000 dollars.

Now let’s look what happens when we trade the XYZ’s share CFD.

Again, we buy on the 17th of November 1000 CFDs of XYZ at 10 dollars. The value of our position is 10x1000 which is equal to 10000 dollars. On the same day, we closed the trade at 11 dollars. The value of the position became 11x1000 which is equal to 11000 dollars. Total profit for the trade is also 1000 dollars.

In other words, there is no difference between buying the share and its CFD.

Types of Contracts For Differences (CFDs)

Contracts For Differences exist for (1) currencies, (2) cryptocurrencies, (3) indices, (4) equities, and (5) commodities.

Currencies like EUR/USD, GBP/USD, and USD/JPY; cryptocurrencies like Bitcoin and Ethereum; indices like the US500, DAX and JP225; equities like Microsoft, Apple and Alibaba; and commodities like gold, oil, silver and sugar.

Advantages of Trading CFDs

Trading CFDs has several advantages. These include (1) the ability to trade both long and short positions, (2) the ability to trade using leverage, (3) faster execution of trades and lower costs, (4) small contract sizes, and (5) trade without physical delivery.

When trading CFDs, investors can trade both long and short positions, thus profiting from both rising and falling markets. Investors can trade using leverage which can increase profits, but also the risk. CFD trading allows for fast execution and low transaction costs. Small contract sizes allow investors to buy portions of the underlying asset. For example, light sweet oil futures have a minimum contract size of 1000 barrels. Its CFD starts from 25. Lastly, trading CFDs requires no physical delivery, thus, you limit the risk of having to worry about the asset, its storage, insuring it, and more.

Disadvantages of Trading CFDs

Trading CFDs also has its disadvantages. These include (1) lack of ownership and therefore, voting rights, (2) positions are nontransferable, (3) trading using leverage increases risk, (4) the risk of overtrading.

CFD owners, for example, have no voting rights since they don’t own the asset or stock. CFD positions cannot be transferred to a different CFD provider or broker. Trading with high leverage increases risk. This means that potential profits are magnified but it is also important to remember that losses are also magnified. Ease of access and low capital requirements can lead to overtrading. Swaps are charged.

Some Examples of CFDs

Example 1

Comparing APPLE share and APPLE CFD. Starting with the APPLE share.

On the 27th of October, we bought 10 APPLE shares at the New York Stock Exchange at 160 dollars. The value of our position is equal to 10x160=1600 dollars. With a minimum commission rate of 15 dollars per transaction, we would be charged 15 dollars. Other fees are at 5 dollars. Since no leverage is provided, the margin requirement is 100%. Total amount payable is 1600+15+5 which is equal to 1620 dollars

Now let’s look what happens when we trade the APPLE CFD.

We also bought on the 27th of October 1 lot of the APPLE CFD, where 1 lot equals 10 shares, so in order to buy 10 shares, we need to buy 1 lot at 160 dollars. The value of our position is equal to, again, 10x160=1600 dollars, same as its share equivalent. With a commission rate of 0 dollars and no other fees, we would be charged nothing. CFDs also provide leverage. In this example, the margin requirement is 5%. So, in this case, the total amount payable is 1600x5% which is equal to 80 dollars.

The following becomes evident after opening the position: (1) trading the APPLE CFD requires less margin, meaning less money in your account for the same transaction, and (2) transaction costs are less, giving the investor more room to profit from the position.

Let’s see what happens when we close the position after 5 days, on the 3rd of November 2017.

The APPLE share price has gone up to 174 dollars. The value of our position is equal to 10x174=1740 dollars. With a minimum commission rate of 15 dollars per transaction, we would be charged 15 dollars. Other fees are at 5 dollars. The total amount received becomes 1740-15-5 which is equal to 1720 dollars. This gives a profit of 100 dollars, giving a return on capital of 6%.

Now let’s look what happens when we close the APPLE CFD position at the same time.

The APPLE CFD price has also gone up to 174 dollars. The value of our position is now equal to 10x174=1740 dollars. On the CFD, there are no commissions and other hidden fees, but we pay swaps, which is the cost of holding the position overnight. Swaps of 1.6 dollars per day for 5 days is equal to 8 dollars. The total amount received becomes 1740-8 which is equal to 1732 dollars. This gives a profit of 132 dollars, giving a return on capital of 165%, because leverage gave us the advantage of using only 80 dollars as capital, instead of 1620 dollars.

The following becomes evident after closing the position: the ability to leverage can magnify both the return on capital and the risk.

Example 2

Comparing Bitcoin cash and Bitcoin CFD. Starting with Bitcoin cash.

On the 1st of October, we bought 1 Bitcoin cash at an exchange of 5000 dollars. The value of our position is equal to 1x5000=5000 dollars. With a transaction fee of 1%, we would be charged 5000x1%, which is equal to 50 dollars. With a 0.3% deposit and other fees, we would be charged 5000x0.3% which is equal to 15 dollars. Since no leverage is provided, the margin requirement is 100%. The total amount payable is 5000+50+15 which is equal to 5065 dollars.

Now let’s look what happens when we trade the Bitcoin CFD.

We also bought on the 1st of October 1 Bitcoin CFD at 5000 dollars. The value of our position is equal to, again, 1x5000=5000 dollars, same as its cash equivalent. With a transaction fee of 0%, we would be charged nothing. With a 0% deposit and other fees, we would be charged nothing again. CFDs also provide leverage. In this example, the margin requirement is 20%. In this case, the total amount payable is 5000x20% which is equal to 1000 dollars.

The following becomes evident after opening the position: (1) trading the CFD Bitcoin requires less margin, meaning less money in your account for the same transaction and (2) transaction costs are less, giving the investor more room to profit from the position.

Let’s see what happens when we close the position after 5 days on the 6th of October.

The Bitcoin cash price has gone up to 5700 dollars. The value of our position is now equal to 1x5700=5700 dollars. With a transaction fee of 1%, we would be charged 5700x1% which is equal to 57 dollars. With a 0.3% withdrawal and other fees, we would be charged 5700x0.3%, which is equal to 17 dollars. The total amount received becomes 5700-57-17, which is equal to 5626 dollars. This gives a profit of 561 dollars, giving a return on capital of 11.09%.

Now let’s look what happens when we close the Bitcoin CFD position at the same time.

The Bitcoin CFD price has also gone up to 5700 dollars. The value of our position is now equal to 1x5700=5700 dollars. On the CFD, there are no transaction and withdrawal or other fees, but we pay swaps, which is the cost of holding the position overnight. With swaps of 5.5 dollars per day per unit, the cost is 27.5 dollars. The total amount received becomes 5700-27.5, which is equal to 5672 dollars. This gives a profit of 672 dollars, giving a return on capital of 67.20%, because leverage gave us the advantage of using only 1000 dollars as capital instead of 5065 dollars.

The following becomes evident after closing the position: the ability to leverage can magnify both the return on capital and the risk.

Recap!

Contracts For Differences

Financial derivatives that allow investors to participate in the movement of asset prices without full ownership of the asset.

Types of Contracts For Differences

  • Currency CFDs (e.g. EUR/USD)
  • Cryptocurrency CFDs (e.g. Bitcoin)
  • Indices (e.g. US500)
  • Equities (e.g. Apple share)
  • Commodities (e.g. oil)

Advantages of CFDs

  • Ability to trade both long and short positions
  • Ability to trade using leverage
  • Faster execution of trades and lower transaction costs
  • Small contract sizes
  • No physical delivery

Disadvantages of CFDs

  • Lack of ownership and therefore, voting rights
  • Positions are nontransferable
  • Increased risk due to
    • Trading using leverage
    • Overtrading

Share vs. CFD

Share

CFD

Higher margin required

Lower margin required

Higher transaction fees

Lower transaction fees

Leverage increases propensity for profits and risk

In our next video, we will talk about Cryptocurrencies. Thank you for watching!