What is a CFD?
CFD is a contract for difference, a contract between you and your CFD provider to settle the difference in cash between the price at which you buy the CFD and the price at which you sell.
The price of the CFD mirrors the price of the underlying instrument (share, index or metal price).
It means, for example, that instead of buying and selling physical stocks, the CFD buyer gets access to the performance – price movements of the same stocks - without ever having to take delivery of them. CFDs originated in 1980s in the interbank market, they are used by the banks and institutions to hedge their share positions and are known as equity swaps.
An example of CFD transaction.
You believe that XYZ shares will rise in price and decide to buy ( this is also called “going long”) 1000 XYZ shares at the market price of $4.45. The value of your CFD position is $4450. You are required to have 5% margin to secure your position. 5% of $4450 is $222.5.
After 3 days the price of XYZ shares went up as you have expected and you decide to close the position at the price $4.52. Your profit is calculated as the difference in the price you entered and exited the trade, multiplied by the size of the position:
1000 x 12 cents = $120
In 3 days you made a profit of $120 from the initial investment of $222.5. If you would buy the same number of shares the traditional way you would have to invest the amount equal to the value of shares - $4450.
You can also “go short” with CFDs, meaning that you can enter a sell transaction and profit on the falling market.
In this case you believe that the shares of XYZ will fall in the next few days and you sell 1000 shares at the current price $4.50 per share.
Again, like in the previous example, you would be required to have a margin of at least 5% to secure your position. The margin is $225 (5% of $4500).
A few days later the XYZ share price has fallen down to $4.30. You decide to close your position by entering an opposite transaction – simply by buying CFDs for the same number of XYZ shares. Your profit is the difference between the price you sold the CFDs for and the price you bought them back: 1000 x 20 cents = $200.
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