What is a CFD?
A contract for difference (CFD) is an agreement between two parties to exchange the difference in the value of a security. For example, if you have purchased stock worth €10 per share, but its value drops to €4 per share, the other party in the CFD agrees to pay you the difference or €6 per share. Similarly, if you’ve sold stock worth €4 at €10, then that party would pay you the difference or €6 per share. The term “contract” may be misleading because no delivery of securities takes place under this agreement.
Let’s take a look at an example:
You buy 20 shares of ABC company with 1 dollar each. The next day, the value of that share goes up to 1.5 dollars per share. A CFD provider offers you to open a CFD position wagering on the rise of ABC stock. Your trader opens a long position at 50 dollars per CFD (1 euro = 1 dollar), which means you will receive 100 dollars if they close it now (50+50). If they go down, your loss will be 100 bucks.
Two days later, the price of ABC company shares goes up to 2 dollars per share, and you decide to close your position. You sell your 20 shares for 40 bucks each and collect 800 dollars in total (20*40), minus trading fees, if any. The trader closes the CFD position by repurchasing it at a different price. Your CFD account will show you a loss of 100 bucks (50-150).
Remember that CFDs are leveraged products, meaning that you only need to put down a small deposit or margin % compared to the total notional value of your position. For example, 100 dollars is 4% of 5000 dollars when trading CFDs on ABC stock.
What are margins & What are typical margin requirements for securities?
A security deposit is required before any trade takes place. If you want to open a long position on ABC company shares, you have to come up with some cash first. A portion of this money is set aside as a margin and is frozen until the position is closed.
The percentage of the total security value needs to be deposited as a margin for a trader to enter into a CFD trade. The margin requirements for ABC company shares might be 2% (2000 dollars out of 100,000), meaning that you will need to deposit at least 2000 dollars to open a long CFD position on these stocks.
Why do CFDs require margins? In other words, what are the benefits of using margins when trading CFDs?
Margins provide traders with two essential benefits: First, they allow traders to open positions more significant than their account balance, thus giving them the potential to make more significant profits. Second, they provide traders with a degree of protection against losses. If the market moves against their position, their losses are limited to the amount of margin they have deposited.
What are some risks associated with CFDs and margins?
One risk associated with CFDs is that they can be highly volatile and thus result in significant losses. For example, if you open a long position on ABC company shares at 50 dollars per CFD and the stock subsequently falls to zero, you will lose all your money (50+50+100). In addition, CFDs are leveraged products, and so your losses can be greater than the amount of margin you have deposited.
Many other risks are associated with CFDs, including interest rate risk, counterparty risk, and transaction costs. Make sure you thoroughly understand the risks before trading these products.
Summary of CFDs and margins
In short, CFDs allow traders to speculate on the price movement of securities without actually owning them. To do this, they need to deposit a margin, a security deposit that provides them with protection against losses.
Margins provide traders with two essential benefits:
- First, they allow traders to open positions more significant than their account balance, thus giving them the potential to make more significant profits.
- Second, they provide traders with a degree of protection against losses. If the market moves against their position, their losses are limited to the amount of margin they have deposited.