Table of contents:
- 1 What is a CFD?
- 1.1 What are the advantages of CFDs?
- 1.2 The use of leverage
- 1.3 Ratio between leverage and margin to be deposited
- 1.4 CFD trading in practice
- 1.5 Example – Buying a long position (share CFD)
- 1.6 Transaction costs
- 1.7 Example – Purchase of a short position (stock CFD)
- 1.8 Should trades be closed at the end of the day?
With a concrete example we would like to show you how CFD trading works in practice.
First of all, let’s briefly review the basics of CFDs:
With CFD trading, you as a trader have the opportunity to profit 1:1 from rising or falling share prices without having to own the share in question yourself. You buy a so-called Contract for Difference, or CFD for short.
If you think that the price of a share is rising, you buy a long position. Conversely, in expectation of a falling share price, you buy a short position.
What is a CFD?
Many people have heard of CFDs, but some people don’t know what they are exactly. The special thing about CFDs is that you do not trade directly on the stock exchange or exchange shares, commodities etc. with other traders, but that it is only about the relationship between the trader and his broker. In practice, however, this construction makes no difference for the trader. In the ideal case, the broker will give the trader exactly the same price for a share etc. that is currently on the exchange. In fact, there are even some advantages for the trader by using CFDs.
What are the advantages of CFDs?
CFD AdvantagesA big advantage of CFDs is that you can trade with a smaller account size. With some brokers this is possible with a deposit of 10 Euro on the trading account. However, in order to be able to trade sensibly, you should deposit at least 1,000 euros into your account. For example, if you want to trade the Dax (German stock index), you have two basic options. In the past, there was only one option, namely the so-called DAX Future. This has the disadvantage that one point is worth 25 euros.
Suppose the Dax is currently at 12,000 points and you buy a Dax future. If the Dax rises by only 10 points, this means that you already win 250 Euros. On the other hand, you can also lose 250 Euros very quickly in this way. As you can see, trading futures is therefore not ideal if your account is not yet large enough. With CFDs, however, the whole thing looks completely different: Here a CFD with a Dax corresponds to exactly one Euro. Therefore, a change of 10 points also earns or loses you 10 Euros.
The use of leverage
When trading CFDs, you can also use leverage. This means that you can trade much larger amounts than you actually use. The own use is called margin or security deposit.
Leverage of 5, usually expressed in the notation 1 : 5, means that only 20% margin is required for 100% of the contract size. 95 % of the contract is financed by a loan. So if you buy a CFD of 100 € with a leverage of 1:5, the stake or security deposit is exactly 20 €.
Ratio between leverage and margin to be deposited
Lever 1 – corresponds to 100 % margin
Lever 5 – corresponds to 20 % margin
Lever 10 – corresponds to 10 % margin
Lever 20 – corresponds to 5 % margin
Lever 30 – corresponds to 3.33 % margin
Lever 40 – corresponds to 2.5 % margin
Lever 50 – corresponds to 2 % margin
Lever 100 – corresponds to 1 % margin
It should be noted that trading in leverage for private investors was restricted some time ago by the European financial supervisory authority ESMA. For CFDs on shares the highest leverage is 1 : 5, which means that a security deposit of 20% must be deposited. CFDs on indices such as the Dax as well as on commodities or precious metals can be traded with a leverage of up to 1:20.
Note: Higher leverage always involves a higher risk of loss up to the total loss of the account balance.
CFD trading in practice
CFD trading in practiceNow that you know the advantages of CFDs, it is time to illustrate CFD trading with a concrete example: Let’s assume that you have an amount of 10,000 Euros in your trading account. With this amount, by the way, it is realistic to make an average profit of 2,000 Euros per month. For trading, you should observe the following rule: Per trade you should risk a maximum of 1% of your trading capital. This means that with a trading account of 10,000 Euros, you can risk a maximum of 100 Euros.
In order to trade, it is important to know how a trend is structured: As you have certainly heard, there are up, down and sideways trends. To be able to speak of an uptrend, the price must form both higher highs and higher lows. In the case of a downward trend, the situation is exactly the opposite. Thus deeper lows and deeper highs must be formed. A trend always consists of the two parts movement and correction: Assume that the price of a share is 100 euros. The price then rises quickly to 150 euros (movement phase). After that, the price falls slowly and uncleanly towards 125 Euros (correction phase).
A characteristic of a trend is that it is more likely to continue its direction of movement than to suddenly move in the opposite direction.
In order to trade the Dax, for example, the following procedure is recommended: You wait until the trend is in the correction phase. Assuming the Dax has risen from the 12,000 points to 12,100 points. Then the price begins to correct in the direction of 12,050 points. At this point, a good opportunity to enter with a CFD is to buy a Dax CFD.
After the purchase, the price initially drops further to 10,040 points, so that you are in the red with 10 points or 10 Euros. After that, however, the movement phase begins again and the price rises rapidly to 12,090 points, so that there is now a realized profit of 40 points or 40 Euros. After the price has broken through the previous high of 12,100 points, it rises quickly to 12,140 points. Therefore, the position now has a profit of 90 points and you can think about realizing the unrealized profit and thus closing the position.
The nice thing about CFDs is that they are ideal for pyramidizing: If the trade goes well, you can simply double your position by buying another CFD. Of course, you can also triple or quadruple your position. This of course also multiplies the profit: 90 Euros become 180 Euros, or even 270 Euros or 360 Euros. As you have hopefully seen in this small example, trading CFDs is not witchcraft and with a little practice anyone can trade on the stock exchange.
Let us assume that one share currently has a price of €100. You expect the price to rise in the next few hours. You decide to invest 200 € and want to trade with the maximum possible leverage of 1:5.
The 200 € of your own stake, which is also the security deposit, corresponds to 20% of the total amount traded. In total, the CFD moves a capital of 1,000 €.
The price of the share actually rises to 101.60 € and you sell the position again. The profit then looks as follows:
The stock has increased in value by 1.6% or €1.60. With a leverage of 1:1 you would have profited with your CFD in the same proportion. On the 200 € invested, you would have been credited with 1.6% profit or 3.20 €. With a leverage of 1:5, the profit is multiplied by 5. The profit is now 16 €, based on the 200 € you bet yourself.
If, contrary to expectations, the share price falls to 99 € and you automatically sell the position, for example with the help of a stop loss, you have made a loss. With a leverage of 1 : 1, the loss is exactly 2 €, and with a leverage of 1 : 5 it is 10 €.
Tip: Always trade with a stop loss. You can usually set this as a percentage of the contract size or as an absolute (loss) amount in euros. A stop loss should always be set before entering into a position. However, it is possible to adjust the stop loss during the course of a trade.
In practice, additional fees for the transaction must also be taken into account. The fees are usually indicated in the form of a spread, i.e. a bid-ask spread (bid-ask). The spread is calculated each time a CFD is purchased. It reduces the potential profit from the CFD position.
Some online brokers allow you to trade at fixed spreads, while other online brokers offer variable spreads that can change in certain market situations.
For example, if the spread is 0.20% (in relation to our share at the price of €100 this would be €0.20), you can effectively buy the virtual share with the CFD only at a price of €100.20. The share must therefore first exceed a price of 100.20 € to make a profit with the CFD.
The profit from the CFD position with 200 € stake at a leverage of 1 : 5 is therefore with an exit price of the share of 101.60 € actually only 6.99% or 14 €. This shows that even small differences in the spreads can lead to large deviations in the actual profit.
Example – Purchase of a short position (stock CFD)
Let us again assume a share with a current price of €100 and a capital investment of €200. This time, however, a falling share price is expected. With a leverage of 1:5, a capital of 1,000 € can also be moved with the share CFD. So you buy a CFD Short over €1,000 and must deposit 20% Margin of €200.
Let us assume that the price actually falls to €98.5. This means that the share has suffered a loss of 1.5% or €1.50. If you bet 200 € on the CFD Short with a leverage of 1:1, this means a profit of 1.5% or 3.00 €. With a leverage of 1:5 the profit is 15 €.
If, in turn, a spread of 0.20% is taken into account, the short position on the share can only be bought at a share price of 99.80 € reduced by the spread.
If the CFD position is sold at the share price of 98.50 €, this results in a profit of 1.3% or 2.60 € based on 200 € stake with a leverage of 1:1. With a leverage of 1:5 the profit is 13.00 €.
If, contrary to expectations, the share rises to 101 €, this means a loss of 10 € for the CFD with a size of 200 € and a leverage of 1 : 5, without taking the spread into account.
Tip: Even with short positions, you should only trade with a stop loss determined before entering the position. A Take Profit order supplement for automatic profit taking by closing the position at a certain price level is also helpful.
Should trades be closed at the end of the day?
For leveraged CFDs, a large portion of the total position is financed by a loan. Depending on the online broker, different interest rates are charged for this if the position is held overnight. The interest not only reduces the profit, but also increases possible losses.
In addition, the prices at the opening of the stock exchange the next day can possibly experience very large swings due to new information coming onto the market, which may run against the trade and drastically increase the losses.
We therefore advise prospective traders to consider carefully whether they really want to hold CFDs for a long time. CFDs are by no means suitable for medium to long-term investments.
Tip: If you are looking for comprehensive trader training, you should take a closer look at our training courses. For those who have already gained some experience, but are looking for profitable signals, we recommend the stock round PowerSignals.
Read my other articles about CFD Trading:
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- What is CFD Trading? – Ultimate Guide For A Profitable Start