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How do share CFDs work

 

If you’re looking to get into trading shares, CFDs can be a relatively simple way for you to get started.

However, there are a number of key risks that come with CFDs, which is why it’s important to thoroughly understand how they work and what those risks are.

That’s what our beginner guide to shares CFDs is all about.

 

So, how do shares CFDs work?

When you trade shares in the traditional way, you own them. (You’re a shareholder.)

So, if you buy 10 Apple shares, you are an Apple shareholder. If your share price goes up and you sell your share, you profit from the difference in price.

With CFDs, though, you don’t own the shares. Instead, you’re simply speculating whether the share price will go up (or down).

You’re still hoping to profit from movements in the share price, but using CFDs is in some senses a more simple way of doing so.

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CFD stands for ‘Contract for Difference’

In a CFD, you and the CFD broker agree to exchange the difference between the price of an asset when the contract opens, and the price of an asset when it closes.

You choose how many contracts you want to open at once, and this dictates the total size of your trade.

It’s fairly easily to calculate how much your share CFD trade is worth, because the price of one contract is the same as the price of one share of the company.

Here’s a basic example of a CFD shares trade.

You decide to open a trade on Company A’s share price. Each share is worth $150 when you open the contract.

You decide to open 10 contracts, and go long on your trade. (Which means, you speculate that the price of the share will go up.)

The total size of your trade is $1500. (10 contracts at $150 each.)

Over the next few hours, the price of each share increases to $175. You close the trade.

The difference between the opening price ($150) and the closing price ($175) is $25. This is your profit on each contract.

You opened 10 contracts in the trade, which means your total profit in this case is $250. (10 contracts with a $25 profit each.)

This is a simplified version of a typical shares CFD trade. (Though you will also have to take your margin into account.)

As you can see, it’s relatively simple to calculate your positions and potential return once you get the hang of it.  

However, there’s a bit more to most share CFD trades. The majority of them make use of leverage.

 

How do share CFDs work

 

How share CFDs use leverage, and what you need to know

Leverage allows you to place larger trades than you might otherwise, by borrowing money from your CFD broker.

Let’s go through another example:

Let’s say you want to place 50 contracts of Company B’s stock, which is valued at $1,000 per share.

This gives you a total trade size of $50,000. (50 contracts at $1,000 each.)

You don’t want to provide the full $50,000 capital (plus margin) upfront.

So, your broker allows you to use leverage of 1:20.

To calculate how much capital you’ll need to supply upfront when using leverage, you need to divide the total size of the trade (which is $50,000) by the second, larger number in the leverage figure (which is 20 in this case).

So, to place this $50,000 trade using leverage of 1:20, you’d need to provide $2,500 in upfront capital.

 

Calculating profit and loss on leveraged CFDs

 

How do share CFDs work

 

It’s important to understand that when you use leverage on CFDs, your profit and losses are calculated on the size of the trade, NOT on the money you put in.

This means you can lose more money than you put into the trade.

Let’s look at our $50,000 example trade again.

Say that you make a 10% profit on this trade.

This would give you a total return of $55,000, and a profit of $5,000.

You only supplied $2,500 in actual money to place the trade, so although your profit on the trade is 10%, your actual monetary return is 100%. (You’ve doubled your money on the trade.)

However, this principle also applies to your losses. Had you lost 10% on the trade, your total loss would have been $5,000 – twice the money you put in.

It’s for this reason that many traders choose not to use leverage at all. They deem the risk of losing more than your initial capital to be too big.

 

Summing up

CFDs can be an effective way to trade shares, and can allow you to go long and short with relative ease. They also free you from any issues arising from being a shareholder.

However, CFDs are classed as a high-risk instrument, and the use of leverage means you should always do your research before you take on any risk.

And, as always, do not trade with money you can’t afford to lose.

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