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CFD

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Spread is a term that relates to price.When trading in the CFD there will be an Offer price and a Bid price quoted by the broker platform. The Offer is the best price at which you can execute a buy trade and the Bid price is the best price you can achieve if selling. The difference between the two prices is the Spread.The City Index platform is below quoting the ability to trade in Danone CFD and Sell at 62.550 and Buy at 62.580. The Spread in this case is 0.03 Euro Cents.Spread is largely driven by market liquidity. Generally the case is that the greater the amount of trading activity the tighter the spread will be. More buyers and sellers being present means there is more chance of finding someone who takes the other side of the trade to you.Particular instruments can see the spread narrow or widen according to liquidity in the market, for example, due to time of day. Although it’s pretty much possible to trade some Index and Forex CFDs 24-hrs a day the spread will typically be tighter during what are seen as ‘market hours’ and will then widen when markets are quieter.Other instances of Spread widening can be during times of extreme market volatility. At those times the spread widens because market participants are unsure of a realistic value and are reluctant to take on a position that they might not be able to move on if the market in general is undergoing extreme shifts.You will also find different Broker Platforms apply different spreads on the same CFDs. As Spread is a cost that you have some control over, shopping around for the tightest Spread is a quick win and should form part of your Broker Comparison Analysis.
Meeting your target of making a profitable return from CFD trading benefits from an understanding of the costs involved.Margin and financing charges are likely to be the most direct costs on your trading account. CFD trading uses leverage so whilst your deposit of ‘margin’ allows you to take larger trading positions the cash used to make those trades will be reflected on your account as a debit or credit balance. Put another way, if you deposit £2,000 with a broker platform and instruct them (using leverage) to buy a position with the value of £8,000 then the actual cash debit reported on your account is in excess of your deposited amount of £2,000. The broker will apply financing costs associated with holding that negative cash balance with them.This will be shown as a margin/financing charge and applied to your account daily.The below statement is taken from a Demo account with markets.comThe top line of the report shows a position in the CFD WPP which was traded 30th of the month and sold one day later on 31st. As this position was held overnight it incurred one days financing costs of £1.24. The second row shows a position that was opened and closed on the same day. This intra-day trading does not incur financing costs.Further down the report we see the same principles being applied to different instruments where financing costs are applied to trades in UK Futures CFD should positions be held overnight.Source: markets.com Demo account 20181128As you’d expect the broker platforms allow you to filter and analyse costs. The below snap shot of the same demo account shows year to date (Ytd) successful trading has taken the capital balance from £10,000 to £12,346.85 with ‘Commissions and Financing’ costs being shown as a Ytd total of £197.84.Source: markets.com Demo account 20181128Other costs associated with trading are less direct in nature.Most broker platforms don’t charge commissions on CFD trading but whilst there are no direct commissions applied the spread which is considered in more detail here can be considered a cost. Opening a trade in a position with a large spread can result in a double take when notice your position is immediately in the red and needs to see some favourable price movement to just cover the spread. It’s worth investing some time in comparing the respective broker platforms, particularly the spreads each offer in different markets to ensure you’re trading under the best terms possible.One common error among new traders is the tendency to ‘trade too much’. A clear strategy for the life of a projected trade can not only help with managing market risk but also provide clear entrance and exit points for a trade.Trading CFDs rather than Shares means that some privileges associated with holding Shares in your own name are given up.If you trade into a long equity CFD position it is questionable whether you will receive dividends associated with the stock. This is because it is not your name that is on the Shareholders Register and in the same way you would not be entitled to the voting rights associated with corporate events such as mergers or takeovers.If you follow the policy of most institutional investors you’ll also factor in the ‘cost’ of the interest you could have received placing your margin deposit in a cash savings account. It might not be a material amount with interest rates where they are currently but should be applied if only to carry out best practise.Part of the popularity of CFD trading is that direct costs that are applied are done so relatively straightforward manner. The more opaque costs whilst taken into consideration might not be a significant factor in terms of your actual trading strategy. Ultimately the ‘cost’ with the largest possible impact is the risk of losing some or all, of your initial capital sum. There are a multiple ways this can happen and some are outlined here. [Link to: What are the risks of trading with CFD?] Some might be within your control; some may be out of it, but they need to be considered.
The reasons for the existence of CFDs are many and varied and they go some of the way to answering the question, “why you want to go to the trouble of setting up and trading a synthetic representation of an asset, instead of trading that underlying asset itself?”A good place to start is the London equity market in the 1990s which is where CFD trading began. At that time, brokers (who don’t pay UK stamp duty on share purchases) began offering UK equity CFD products to those traders who would otherwise be liable for the 0.5% stamp duty on purchases of UK stocks. By not buying the underlying stock in their own name, traders could use CFDs to take on trading positions but incur lower transactional costs when doing so.That aspect of the UK tax regime has changed little since the 1990s and traders with a shorter-term investment outlook continue to benefit from using CFDs to gain exposure to UK equity markets. But, whilst necessity to reduce costs proved to be the mother of invention, the growth of CFD use, out of the UK equities market into other asset types and other regions, reflects that CFDs have additional characteristics that make them popular to trade.

Leverage

When trading CFDs, you the trader are not required to put up funds equating to the total value of the transaction. Instead you place margin with the other party such as a trading platform. That allows traders to get exposure to a larger trading position than if they had to fully fund their trade. A note of caution here – the principles of leverage apply to losses just as they do to profits.

Short Selling

Using CFDs means it is possible for you to ‘sell short’ a particular instrument. The P&L associated with your trading position will still be the difference between prices of your opening and closing trades, but you will in this instance make profits if the price falls, and losses if the price rises.

What can’t you do?

If you are holding a CFD position, and therefore are not actually in possession of the underlying instrument, your name will not be the one that appears on the register of shareholders and that means that some advantages of being a shareholder may be lost.A holder of an equity CFD would not be entitled to the voting rights associated with corporate events. As the broker rather than the trader would be recorded as the holder of the shares and so it would be the broker, if anybody, that would be entitled to vote on events such mergers and takeovers.The same logic extends to dividends on equity CFDs. If you trade into a long equity CFD position it is highly unlikely that you will receive dividends associated with the stock.Financing costs are something else to factor in when trading on leverage. Taking a purchase (long position) as an example, the broker platform will record that it has gone into the market to make the trade to the full value of the holding. The cash used to do that will be reported as a negative balance on your trading account and will incur financing costs each day the position is active.The terms associated with trading CFDs may differ across the respective broker platforms and comparison can be made using Broker Comparison link.
As many people are already make a living out of trading CFDs the answer to the question has to be ‘yes’. However, trading CFDs is a risky business with the very real prospect of losing the cash amount that you start out with. At this point it’s worth considering your motivations to trade, your chosen risk return ratio, and your available resources. If income stream is your primary aim, then a fundamental factor influencing your approach is that the same absolute cash returns can be made applying a lower risk strategy to a larger capital stake or alternatively adopting a higher risk/return approach on a smaller investment.Developing a structured approach to trading is commonly regarded as something that might mitigate the risks involved. Popular advice is to start trading in small non-material amounts and gain a real feel for the market. Demo accounts can help, but a live account exposes you to a more realistic set of emotions. This is a good time to consider different trading strategies and which market or instruments work best for you. Whilst general market knowledge is always beneficial there is much to be said for specializing in one area. Try to understand why, for example, trading Crypto in sideways markets might work for you (now) but be aware of how markets change and how when they do your strategies might need to adapt.Spending time trading in small sizes can also help iron out some bad habits. Are you trading too much? Wearing away your capital amount by churning through trades is commonly held to be a common failing. Are you managing your risk appropriately? The subject of stop losses and where to set them requires more thought than most people give to it.Other reasons exist for setting up a CFD account. Exploring these whilst trading in very small sizes can help build a bigger picture and allow you more time working on getting things right before scaling up.Trading a CFD account allows an insight into the financial markets and investment returns. It might be you are just inquisitive and want to see how you would get on with trading. If you have other market-based investments, such as a pension, which is being managed by an institutional investor then trading your own account, even with ‘pennies,’ can allow you to benchmark your percentage returns against theirs. Once you’re traded your own account and have managed to make a 5% return using a low-risk strategy you might have an opinion on the costs you are paying for expert management advice.Alpha and Beta are two more subjects to consider and try out in small size trading. Alpha is the ability of a trader or strategy to beat the market. Beta is a measure of the risk associated with trading the general markets. Institutional investors often focus on generating Alpha for their investors as it generates great headlines and big bonuses. Beta when considered as ‘buying the dips’ might not be as eye-catching but can offer significant returns for the person, you, who is actually putting their cash into the market.
There is a long list of risks that apply to CFD trading. Some you might have already given thought to, some may be factors you initially overlooked. While the markets remain beyond anyone’s control the amount of time that you give to studying and understanding risk is something that you are directly in control of, so improve where you can.Regardless of the degree of familiarity you end up having of risk factors it is critical to remain aware of three things:
  1. Each risk factor can single-handedly cause you significant losses and even wipe out your account. Given the nature of markets, it’s often the case that one risk event triggers another until they end up impacting your account in unison.
  2. Some risk factors are unknown to you until they occur. An unexpected ‘Black Swan’ event is one that deviates beyond what is normally expected to happen.
  3. Risk factors are ‘live’. Be aware of the ever-changing nature of each risk factor that threatens your CFD trading.
 Treating risk as a box-ticking exercise is easy but costly. Understanding, measurement and management of risk are addressed here and while understanding the below ‘list of risk’ is a useful place to start, it should be by no means the place you finish preparing to trade CFDs.

Market risk

Market moves against you are a simple enough principle to understand. In CFD trading any losses are magnified due to the use of leverage. Short positions deserve particular mention as a Short Sell can hypothetically incur unlimited losses. Whilst the price of a long CFD can go no lower than zero the price of a short can just keep going up.

Margin Call risk

Trading CFDs involves the putting up of margin and significant losses on your account can eat into this ‘deposit’ pretty quickly. Whether it’s one bad position or losses across your whole CFD portfolio, as the margin is eroded you are left running the risk of being ‘stopped out.’ That is where your positions are closed out by the broker because you do not have sufficient funds placed with them to cover possible trading losses.

Single name risk

Taking a large position in a particular instrument that then forms a significant percentage of your total trading capacity concentrates risk in that one CFD name. You would be subject to general Market Risk but also exposed to events specific to that instrument.

Operational risk

These are factors that might restrict your ability to trade. For example, what would happen if you couldn’t connect to the broker platform due to your own lack of connectivity or possibly more significantly if your broker platform itself went down?

Liquidity risk

Illiquid markets are subject to Gapping the major consequence of which is that you are unable to sell at a previously agreed upon price. Even Stop-Losses may not be honored unless the terms and conditions of your Guaranteed Stop Loss hold firm.

Counterparty risk

A CFD contract relies on both parties meeting their obligations. You will put up margin to cover price moves but your counterparty will not so should they not be able to meet their obligations you will not benefit from any favorable price moves.

Other risk

This intention of this ‘list of risk’ is to provide a framework upon which you can build a better understanding of the, known and unknown, risk factors that apply to your CFD trading.
There is a long list of risks that are associated with CFD trading. Some you might have expected to see, some may be factors you initially overlooked. What is of fundamental importance is that each risk factor has the potential to cause you significant losses and could even wipe out an account. When they act in unison, that’s when things get really ugly.It’s important you get an understanding of each item in ‘The ‘List of Risk’, but to mitigate them it’s crucial to put them into the context of your trading. It might help to develop an approach that breaks ‘risk management’ down into its constituent parts. Establish: What is at risk? How do I Measure risk? And thenmove on to: How do I Manage risk? Ask yourself if you are approaching the subject assuming it is a case of, ‘when’ not, ‘if’ some risk event is going to occur.

What is at risk? 

The capital you put up to trade is the primary focus when considering risk. But your trading discipline is something else that needs to be monitored and managed. Whilst both of these are inter-related building a trading strategy that considers both can help prevent losses.

How to measure risk? 

This is an important step and involves gaining a clear understanding of what risks you are facing, their likelihood, and the impact to your account when they occur. A lot of traders jump straight to ‘risk management’ and find themselves trying to manage something they haven’t exactly identified.

How to manage risk? 

There are a variety of tools and techniques available. One of the most effective is sitting on your hands and remembering the old adage ‘some of the best trading decisions you make involve not putting on a position’.

Measuring risk 

Taking each of the categories of risk outlined in What are the risks of trading with CFD?It’s possible to grade each in terms of perceived likelihood of occurrence, and the degree of impact should it happen. As this risk measurement process should be something that is regularly carried out it’s even possible to itemize if the risk has been upgraded, downgraded or indeed hasnot changed since the last review.
NameLikelihoodImpactLast Update
Market RiskHighHighUp
Concentration RiskLowMediumUp
Liquidity RiskLowHighUp
Gapping RiskMediumHighUp
Operational RiskLowMediumNo Change
Client Money RiskLowMediumDown
Counterparty RiskLowMediumDown
(Could have a link to this to be a downloadable tool)

Managing Risk

Is your risk management policy asking the right questions and is it asking them in the right way?Consider these two questions:
    1. Have you completed your risk management report?
    2. How could you lose 5% of your capital today?
 The first question encourages a box ticking mentality; simply providing a ‘Yes’ means trading can start. The second question leads to more engagement andasks you to play devil’s advocate.Consider the number of once successful investment management firms that go bankrupt. The firms would have had systems and procedures that professional and dedicated staff adhered to, and yet they still went under.Good risk management is about more than just allocating enough time to convince yourself that it’s OK to get on with trading.
Trading using broker platforms presents an opportunity to buy and sell positions that are greater in value than the amount of funds you deposit in your trading account. In the simplest example, you deposit $5,000 into your trading account and then buy (or sell) $15,000 of a CFD. The funds deposited, in this case $5,000, is your margin, and the ratio of your deposit to the size of the total holding is called leverage.This is different from a conventional ‘buy and hold’ equity trading account where cash paid into your account must be at least equal in worth to the value of the instrument you are buying. A further thing to note is that conventional accounts, unlike broker platforms, don’t allow you to sell-short in the market.Reviewing a broker comparison site shows that the amount of margin required can vary broker by broker. Individual brokers will also apply different margin rates across different products and markets. That is because the broker platforms factor in the levels of price volatility associated with different types of markets. The greater the risk of a dramatic price change, the more margin will be required to trade, and accordingly less leverage is possible.The below shows a summary margin report on a live Demo account, in this instance using the one provided by www.markets.com. https://demo-trader.markets.comThis trader opened the demo account with a balance of £10,000After opening and closing some trades Realised Profits are £166.43 so the cash balance is £10,166.43There is an open position currently running and showing an Unrealised Profit of £221.09The Equity in the account is the sum of cash deposited + realised profits + unrealised profits = £10,387.52Used Margin = £1,750.81This figure indicates the sum of the margin currently being used by open positions. It is calculated by adding all of the Initial Margins of the open positions.In this demo account, there is only one open position which is an amount of 5 of the UK100 Futures. A long position, giving the trader exposure to the UK FTSE 100 and with an entry price of 7003.95 Margin is calculated using the formula: Entry price x quantity x leverage = 7003.95 x 5 x 20 = £1,750.81 = the referenced Used Margin number.The ‘real value’ of the position = the current price x quantity. In our example, if the future is trading at 7,046 and we hold 5 the real value = 7,046 x 5 = £35,230.Bringing these things together, after using £1,750.81 as margin to enter the trade and applying a leverage rate of 1:20 the account exposure to the market is £35,230.We mentioned earlier that different broker platforms offer different leverage levels across different markets. The below extract from https://www.markets.com/cfds/ gives an example of the rates across a few instruments. Trades put on instruments in the energy market will have a leverage of 1:10 applied and so would use up the spare margin twice as fast as any further positions in the UK Index.Or to put it another way, following a deposit of £10,000 the account has put on a position equating to about £35,000 and still has spare capacity to put on more trades as the Free Margin is £8,636.70. The way that leverage and margin allow exposure to the market which is much greater than the initial funds deposited must be considered when trading because profits and losses can be considerable in relation to applied funds.