Example:

You have $1,000 worth of Telstra shares, if Telstra increases their price from say $5 to $5.05 then your overall value of TLS shares increases to $1,010.

However when trading with CFD’s it is not the overall value of your position which increases or decreases. Instead the profit or loss is determined from the free equity (cash) you have in your account. Put simply, if the CFD position you hold experiences a loss or gain then your free equity will subsequently decrease or increase

Example:

You have $1,000 of free equity and you are “long” $1,000 in a Telstra CFD (based on a 5% Margin). If TLS decreases from $5 to $4.95 then the free equity in your account will decrease by $200 to $800. The value of your position will remain at $1,000.

What this means to investors is that they must ensure that they have enough free equity to cover their losses, otherwise brokers will close out your positions.

Lets say that a stock is trading at $5 and you believe that the price of it will go up.
The CFD margin on the stock is 5% and the CFD commission charge is $10 per trade.

(This example will highlight the benefits of a small initial outlay with CFD’s in comparison of the outlay with shares to achieve a similar result)

The share price over 3 days increases to $5.20

Position Example A (a long position)

Position Example B (a short position)

In addition to these brokerage fees, depending on the position an investor takes out on a CFD, there are also other charges which may apply.

Interest Charges:

By taking out a “long” position, an investor is required to pay interest on the margin that has been taken out. This charge is usually calculated daily and will be dependant on the quantity of the stock in which the investor has chosen.

On the other hand, if an investor has taken a “short” position, then he will instead be paid interest.

Dividends:

As CFD’s are dependant on the price of the underlying stock, if dividends have been allocated then the relative CFD will also be paid the dividend. However there are a few differences in the way in which this payment of dividend occurs.

The first is that dividends for CFD’s will be paid to investors with “long” positions. However if the investor is “short”, then he/she will be required to pay the dividend amount.

The second difference is that in an ordinary share, dividends will normally take an amount of time after the ex-dividend date before the investor is able to actually physically obtain the dividend amount. However with CFD’s the dividend will be credited or debited (dependent on your long/short position) on the ex-dividend date.

To go “Long“ (Buy)
or
To go “Short“ (Sell)

Taking a “long” CFD position means that an investor has a view that the market is rising, and profits are made as a stock rises.
(ie. You would take out a LONG CFD on Telstra if you believed that their share price would rise)

Taking a “short” CFD position means that the investor has a view that the market is in decline, or will experience a fall in prices. By going “short” an investor is technically selling stock that he/she does not own. In a falling market the investor is then able to buy back the stock at a cheaper price, and hence is able to make a profit. (ie. You would take out a SHORT CFD on Telstra if you believed that their share price would fall).

A CFD is a financial instrument which mirrors the movements of the underlying share or index. In recent times the use and trading of CFD’s have grown very popular as more and more individual investors learn the benefits, flexibility and the increased cost effectiveness which CFD’s provide.

CFD’s give the investor the benefits of owning the stock, without the need to invest in the physical share. Its major feature is that it is traded on margin, meaning that it is geared to enable an investor to take out a position with a much smaller capital outlay in comparison to the actual underlying stock.

Example:

If you open a position in a Telstra CFD with $1,000 of equity capital at a margin of 5%, then your effective trading capital is $20,000.

However, as the ability for greater profits generated though the trading of CFD’s is appealing, investors must also realize the increased risk that comes with trading CFD’s. Whilst greater profits can be achieved, the opposing view must also be taken into consideration. A negative movement in the market will also be multiplied and therefore the risks involved are also increased significantly.

The other point investors must keep in mind is that CFD’s can result in looses which exceed your initial deposit as it is a leveraged product. Inexperienced investors must keep in mind that serious looses can be experienced, and that CFD’s may not be suitable for all people. New CFD traders are advised to ensure that they completely understand of the way in which CFD’s work and the risks involved.

The most effective way to demonstrate the severe risks involved with CFD’s is to use the above example. Hypothetically, if you held a stock worth $5 and invested $1,000 (effective trading capital = $20,000) and the stock above were to fall to $0, then effectively you will loose $20,000. This example does work in the opposite way as well, if the stock rises to $10, then your profit on the position will = $20,000.