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  • CFD trading: how does it work? – TIPS & TRICKS
  • CFD trading: how does it work? – TIPS & TRICKS

CFD trading: how does it work? – TIPS & TRICKS

How do I invest in CFDs?

In the investment world, trading in CFDs is incredibly popular. But why? And how exactly does trading in CFDs work? CFD stands for Contract For Difference . This means that an agreement is made between a buyer and seller in which the difference between the purchase and sale price of the underlying product plays a major role. Trading in CFDs is different in a number of ways from ‘normal’ trading in shares or bonds.

The leverage effect

When trading CFDs, leverage plays the biggest role. This leverage allows you as an investor with a relatively small capital to take on a large position. For example, do you want to take on a position worth €90,000 in shares? Then, thanks to leverage, you do not actually need €90,000 for this. Because as a buyer of a CFD you do not become the owner of the underlying product, the CFD broker finances the position for you. The CFD broker asks for a portion of the value of the position as collateral to cover the risks of possible losses. This portion of the value is usually between 1/10 and 1/400. The exact amount of this portion depends on the type of CFD agreement and the broker. Is a value of 1/50 of the position taken as collateral? Then there is a leverage factor of 50.

Higher returns with CFDs

Thanks to this leverage of CFDs, you can achieve much higher  returns  compared to other investments, on the other hand, the chance of higher losses is also greater. For example, do you trade in shares? Then you can never earn more than the increase in value of the share in question in a certain period. Do you buy €3,000 worth of shares and they show a 10% increase in value? Then you earn 10% of €3,000 is €300.

With a CFD position, the profits and losses can be many times higher. If you buy a CFD worth €75,000 with the same €3,000 as collateral and a leverage factor of 25? Then the same 10% increase in value yields a profit of 10% of €75,000 is €7,500. A difference of no less than €7,200! As with any investment product, higher leverage means higher  risk . For example, if you buy a CFD with a leverage factor of 100? And the share decreases in value? Then your loss will also be magnified by 100. Before you take a large position in CFDs, it is important to be aware of all potential risks. By means of a  stop loss,  you set in advance how far you will go and when you will take your loss. The image below gives a good visual representation of how a stop loss works. 

Long position versus short position

When you trade in CFDs, you can earn or lose from rising and falling price movements. A distinction is made between a  long contract  and a  short contract . With a long contract, you expect an increase in the value of the underlying product and you play on this. You buy the underlying product at a certain price, as it were. Is there a price increase? Then the selling price of this underlying product will increase. As a result, the value is higher when selling than when buying. You will be paid the difference between the two. By means of a short contract, you play on a decrease in the value of the underlying product. Do you expect the selling price to be lower than the buying price? Then you speculate on a decrease in the value of the underlying product. The advantage of a CFD is that you can speculate on both rising and falling prices by means of long and short contracts. If you can conclude long contracts in falling prices and manage to obtain short contracts in the peaks of the price, then you profit twice!

The financing costs of CFDs

When you want to trade in CFDs, financing costs – also called interest – are charged by CFD brokers. This is because you can trade in much larger positions through the leverage of CFDs than when you trade in  shares  , for example . The CFD broker charges the costs of the capital that would be needed to buy this large position. Are you taking a long position through a CFD? Then you pay financing costs to the CFD broker. But are you taking a short position? Then the broker pays you. 

In general, the financing costs for CFDs amount to a few percent per year. The costs are calculated per day. This calculated interest is a compound interest and therefore you cannot simply divide the amount by 360 days. The compound interest is calculated as follows: the annual interest rate is, for example, 2.5% (= 0.025). Then you add 1 to this and do this number to the power of 1/360. You subtract 1 from this result and you express this number as a percentage. You multiply this percentage by the total size of the CFD position and the result is its financing costs per day.

An example: suppose you have purchased a CFD position of 100 shares with a leverage factor of 25. The current price is €5, which brings the total value of the CFD position to €500. Due to the leverage factor, you only need €500 / 25 = €20 in your account to maintain this position. The financing costs of this position are 1.5% per year (0.015). The financing costs per day are then: (1+0.015)^(1/360) = 1.000041. This means a percentage of 0.0041% per day. Do you still have the CFD position open after 48 hours? Then the CFD broker will deduct approximately this amount from your account every day – for a long position. Do you have a short position? Then you will be credited with this amount per day.

CFD trading and practice

Trading in CFD trading is fast and within a short time you buy or sell your position. This means you don’t really have to worry about financing costs. Because the financing costs are calculated per day, but the position is usually sold within 48 hours, the costs of CFDs remain low – usually even €0. 

To make a profit from CFDs, it is much more important to focus on your price targets. It is important to make well-considered choices and speculate on the various price increases and decreases. Always keep in mind that investing in CFDs involves risks. The leverage can give you a nice profit, but it can also work against you. Does your investment go wrong? Then you could easily end up with a huge loss. Therefore, always invest responsibly and do not take unnecessary risks. In addition, it is also important to choose a broker that suits the investment strategy that you use. Use  our comparison tool  to find out which CFD broker suits you best!

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