How does CFD trading work
Deal types and costs
When you trade CFDs you buy and sell contracts that represent a specified amount in the underlying market. For example one standard FTSE contract might be worth £10 per point. When you want to close out a position you simply place a trade in the opposite direction to which you opened it.
While most CFD trades will stay open indefinitely, there are some that have a fixed date and time when your position will end, known as its expiry. This is the maximum time until which you can hold your position, although you can choose to close it before it expires.
CFD deal types fall into two main categories.
A cash CFD contract will usually have a nominal expiry date very far in the future. They are designed to be an ongoing position that can be held indefinitely. You can close your position at any time when the market is open for trading.
Cash CFDs usually have tight dealing spreads, in order to mimic the prices displayed in the underlying market. However, daily overnight funding costs apply if you roll your position from one day to the next, so these contracts are generally best for short-term trading.
A futures contract is an agreement to buy or sell a commodity or financial instrument at a predetermined price with settlement at a specified time in the future. These contracts exist in the underlying market and can be used to trade on assets such as indices and commodities.
Forward contracts are similar. However they don’t exist in the underlying market and instead are created by your CFD provider and priced using an underlying asset. They’re often used to trade on shares or forex.
Both types of contract have a set expiry date, but can be settled before this time. Spreads tend to be wider when trading a future/forward, but overnight funding costs are lower and built into the price. This makes futures/forwards popular for speculating on long-term market movements.
Here is a summary of the main similarities and differences between the two types of contracts:
The cost of CFD trading
As well as the spreads we discussed in the last lesson, there are a few other costs associated with CFD trading. These will apply whether you win or lose, although the amount you pay will vary according to your provider and the dealing strategies you use.
Margin is the amount of money you need as a deposit in your account to open and maintain your positions, so it's a key factor in the affordability of trading CFDs. We explain how margin works in the orders, execution and leverage course.
Different CFD providers will require slightly different levels of margin, and rates tend to vary across markets, according to the underlying conditions.
While you have a position open, your margin payment is assigned to it and can't be used for anything else. However, this money is released as soon as you close the position.
Currency conversion fees
When you place a CFD trade, it will be denominated in a particular currency, and this may be different from the base currency of your account. If so, you’ll have to convert any profits, which may mean paying a conversion fee.
For instance, US shares will normally be denominated in dollars by most CFD providers. In this case, before your account can be credited or debited with any profit or loss, the dollar figure needs to be converted back into euros, which may incur a fee.
Overnight funding charges
When trading CFDs your provider will generally charge you a fee for holding the position overnight (unless you're trading futures or forwards). These are called financing costs or funding charges, and reflect the cost of borrowing or lending the underlying asset. So, for each day your position remains open, you'll accrue additional costs.
Did you know?
What is hedging?
If you have an asset in an existing portfolio that you believe may lose some of its value, you could use a CFD to offset the loss by short selling. For example, let's say you hold £1000 worth of HSBC shares in your portfolio. You can short sell the equivalent of £1000 worth of HSBC shares through a CFD trade. Should HSBC's share price fall in the underlying market, the loss in value of your share portfolio would be offset by a gain in your short CFD trade.
Commission charges on shares
When you place a CFD trade you’re rarely charged commission as most providers' charges are included in the spread. However, in the case of shares many CFD providers match the price of the underlying market, then charge commission for carrying out the trade. This mimics the mechanics of trading shares in the underlying market.
Let's say you think shares in Sports Company N are set to rise, you could take a position with a CFD.
The shares are currently listed at a price of 1545/1547 in the underlying market (the equivalent of £15.45/£15.47). You decide to 'buy' 1000 shares as a CFD. Your provider offers the shares at market price, but charges 0.1% commission on the full value of the position. So the final charge would be calculated as 1000 x £15.47 x 0.1% = £15.47
Note that although you only have to put down an initial margin deposit to open the position, the commission charge is based on its full value in the underlying market.
Lastly, you may find that your CFD trading activity (or lack of it) incurs some other fees, such as:
- Controlled risk premiums – as CFD positions can be subject to slippage, you may be able to protect yourself against this risk by paying a small extra fee for a guaranteed stop (explained in the orders, execution and leverage course). Some providers waive this fee if the stop isn't triggered
- Feature subscriptions – your provider may also pass on the cost of providing certain platform features (eg advanced charting packages, live prices), although they may be willing to provide a rebate for more valuable customers
- Inactivity fees – if you stop trading, your provider may seek to cover its ongoing administrative costs by applying an inactivity fee to your account
- Cash CFDs remain open indefinitely, while futures/forwards have a fixed expiry date
- Funding charges usually apply if you hold a cash CFD open overnight
- Traders are generally charged commission on share CFD deals
- The other costs of CFDs include spreads, margin, currency conversion fees, controlled risk premiums, feature subscriptions and inactivity fees