Introduction
CFDs are often touted as an easy entry point for retail traders, but CFD pricing remains a persistent hurdle for many. CFDs are derivative instruments, and derivatives trading requires a well informed approach.
If you fancy trading CFDs, remember that CFD stands for “contract for difference”, and the difference in question is the price now and the price later. The appeal of CFDs for new traders, especially, must go alongside well detailed research before buying in.
Highlights and Key Takeaways
- With CFDs, the time frame of the contract, and events or inputs that impact the value of the underlying asset upon which the contract is based, determine success.
- There will be a difference between the CFD buy price and the sell price (the spread), and this is often how the broker earns commission－there is no CFD ‘exchange’, merely a contract between you and a brokerage firm.
- CFDs are attractive to many because of margin, which means you only put up an initial token sum to buy the contract. Leverage, in turn, is a measure of exactly how much you have invested in the full value of any particular transaction. It also indicates the ratio of the position size to the invested capital.
- There are various factors that affect the price of CFDs. There is also a comprehensive approach to costing CFDs, and also a way to reduce costs by applying a few basic principles.
Understanding the Basic Concepts
What Is a Spread in CFD Trading?
CFD trading can be more frustrating than genuinely complex, as it’s a simple proposition – will you win or lose based upon price movements of an asset over a specified time period?
In CFD trading, you don’t own the underlying asset, but you enter into a contract that simply tracks the price of the underlying asset, which means you’re speculating on when and how the price of that asset might change. So, you do not physically possess the asset but you can gain or lose money based on its price fluctuations.
The spread in CFD trading is the difference between the quoted buy (ask) price and the sell (bid) price. In other words, once you place a trade and the price moves beyond the cost of the spread, i.e. in your favor, the CFD becomes profitable. Conversely, if the price remains between the spread range, or moves against you, it’s a losing trade.
Explaining Margin and Leverage
The CFD margin is the deposit you’ll need to have in your account in order to trade a CFD. Also called the ‘margin requirement’, margins differ across markets, and they’re typically given as a percentage. This indicates how much of the full value of the position you’ll need to deposit to buy in. Margin calls happen when you’ve funded a trade with just enough to initiate the CFD, which then enters a losing position (for you), in which case the brokerage might close out your trade.
CFD leverage describes being able to trade an asset without making an outright purchase, requiring only the margin, thus gaining leverage. This correlates with the margin requirement when it comes to funds you have designated for investment purposes (and exposure appetite). Profit and loss with CFDs is based on the full value of your position, but leverage can be a slippery slope for the reckless.
The Factors Affecting CFD Pricing
The Role Of Market Volatility
Market volatility’s effects on CFDs can be described most succinctly in two words－widening spreads. This means that the difference between the buy and sell price increases, affecting trading expenses, especially during periods of high volatility. This may not always happen as it is dependent on market conditions and broker policies. Elevated expenses can suck all of the profit out of borderline trades, thus more astute investigation and projection is needed in volatile markets when looking at CFDs.
Market spreads on CFDs usually run in unison with market volatility. Whereas volatility is the grist in many ways for day traders who need volatility to capitalize on price movements; it has its downsides too as many day traders prefer stable market conditions. When spreads widen, tactics should change, and you’ll want to monitor your leverage (exposure) very closely.
Calculating the Cost Of a CFD Trade: A Step-by-Step Guide
As CFDs function as derivatives, you enter into the contract with a margin rather than the full value of the asset in question. This stands to mean that you are borrowing money, and interest charges will apply. There are many minor costs in CFD trading, but they can add up to delete profit on any trade if you don’t factor all costs in at the outset. Commission is one charge you may encounter.
Don’t simply leap at brokers offering “no commission”, because even though they advertise such, they may compensate through wider spreads, indirectly affecting traders.
Holding positions overnight typically attracts a LIBOR+ rate (the London Interbank Offered Rate usually plus 2% – 3%), and interest is calculated on weekend days too－something to factor in. You should also note that your margin (initial deposit) isn’t an offset on interest charged.
The broker will calculate interest on the full value of the underlying asset. Your interest rate will fluctuate at the close of each day’s trading, moving up or down based on the asset’s closing price.
A CFD cost calculation should step through the potential for:
- Trading platform and/or data fees. The monthly charge for this varies among brokerages, and understanding the standing or recurring expenses is important. Many brokers waive these fees as long as your trades are of sufficient volume.
- Possible surcharges for guaranteed stop-loss options managed by the brokerage.
- Commissions paid to the brokerages are typically minimal, but oftentimes these small nips and tucks add up to mean a break-even or losing trade. Smart traders talk net gains, factoring in all the bits and pieces to focus on what a CFD will ultimately, actually pay them, once commission and all other charges are settled.
- As we mentioned above, sometimes there is no commission, but these brokers will typically widen their spreads to compensate, thereby upping your risk. You need to confirm whether the brokerage’s spreads are based on the underlying asset prices or not, and do the math. Similarly, opening and closing prices have a huge impact on profitability.
- Again mentioned above, interest needs to be factored in, and although it often sounds complicated, determining what exactly you will pay in interest. This depends on your position and how long you’re in isn’t hard.
- Slippage, which is what happens when your intended exit price and the eventual exit price differs. Slippage can be a product of the brokerage’s stop-loss execution, share CFD liquidity, or broad market volatility. Smart traders keep it manageable by avoiding illiquid stocks and price gapping－exposing themselves to overnight risk.
- A last consideration concerns dividend adjustments. If you’re in a position on a stock CFD, for example, and a dividend payment becomes due on the underlying asset, you will be credited with almost the same amount as the dividend. The converse is also true if you’re short on equities, where the dividend will be charged to your account.
To a large extent, figuring out your trading costs doesn’t have to follow a particular order, as long as all potential costs are considered. Here, details count, and although traders have a tendency to look ahead to big returns, the reality is more routine. Small percentage fluctuations, alongside unexpected surprises, can erode profitability completely.
Only when you have an exhaustive list of costs can you do the math that will determine actual net profit. This, in turn, reveals a genuine risk exposure, and you can make a legitimate decision about whether a trade will be potentially profitable for you.
Reducing Costs in CFD Trading
Smart traders apply a few basic rules to stay in the Goldilocks zone of CFD trading – shrinking costs, or at least keeping them between manageable goalposts. Liquidity is an important consideration, and the more you move towards illiquid markets, the more likely you are to suffer slippage or price gapping. Highly liquid markets offer the best chance of CFD trading success for this very reason.
Trading during market hours, as far as possible, is another consistent trait of successful CFD traders, and this approach really ties into arguably the most important consideration for reducing costs－discipline! While it would also be fair to say that discipline is a must for any kind of trader or investor, discipline in CFD trading is paramount. This is if you want to accumulate consistent wins over time. When venturing into CFD trading, shop for brokers that you understand and are comfortable with their pricing.
Conclusion
What’s the secret to successful CFD trading then? Understanding the various CFD pricing mechanisms is the legwork that has to be done until you attain a level of mastery. You need to immediately understand what the pricing you’re looking at does for your appetite and your bottom line. It’s an imperative that comes quickly when you constantly evaluate CFD pricing across brokerages and markets.
Having a trusted brokerage on your side is a real asset when it comes to CFDs. Unlike forex and other markets, where service providers can seem very impersonal, CFD trading is “hot” and quick, and trading with a trusted broker goes a long way towards ironing out bumps, getting privy intel, and actually enjoying trading CFDs.
FAQ
How Do You Price a CFD?
CFDs will typically be priced according to the underlying index, or determined by a futures price (duly adjusted for fair value). Such CFDs trade without commission, as the spread will earn the brokerage their keep. CFDs that attract commission will be more attractive in the spread, and the commission will be captured on your “in and out”.
How Much Is 1 Lot in CFD?
Lots of CFDs correlate with their underlying assets. As an example, 1 CFD lot for crude equals 100 barrels. Lots denote the size of a transaction and this guides traders as to their exposure (risk) and potential profits.
Is Trading CFDs Safe?
Trading CFDs is “safe” in terms of being a standard trading practice where you’re dealing with reputable brokerages. They’re attractive to day traders as they allow them to employ leverage trading assets that would otherwise be too costly to consider. CFDs come with inherent risks, as they are not as strictly regulated as other financial products. Traders should also be aware of the possibility of a lack of liquidity, and the potential for significant losses due to leverage. It is important to exercise caution and manage positions carefully when trading CFDs.
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