Calculate Cfd Leverage – Pacific Futures

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An Introduction to CFDs

The contract for differences (CFD) offers European traders and investors an opportunity to profit from price movement without owning the underlying asset. It’s a relatively simple security calculated by the asset’s movement between trade entry and exit, computing only the price change without consideration of the asset’s underlying value.   This is accomplished through a contract between client and broker and does not utilize any stock, forex, commodity, or futures exchange. Trading CFDs offers several major advantages that have increased the instruments’ enormous popularity in the past decade.

Key Takeaways

  • A contract for differences (CFD) is an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product between the time the contract opens and closes.
  • A CFD investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset.
  • Some advantages of CFDs include access to the underlying asset at a lower cost than buying the asset outright, ease of execution, and the ability to go long or short.
  • A disadvantage of CFDs is the immediate decrease of the investor’s initial position, which is reduced by the size of the spread upon entering the CFD.
  • Other CFD risks include weak industry regulation, potential lack of liquidity, and the need to maintain an adequate margin.

How a CFD Works

If a stock has an ask price of $25.26 and the trader buys 100 shares, the cost of the transaction is $2,526 plus commission and fees. This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a CFD broker requires just a 5% margin, or $126.30.

A CFD trade will show a loss equal to the size of the spread at the time of the transaction. If the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the break-even price. While you’ll see a 5-cent gain if you owned the stock outright, you would have also paid a commission and incurred a larger capital outlay.

If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1,263 = 3.95% profit. However, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market.

In this example, the CFD trader earns an estimated $48 or $48/$126.30 = 38% return on investment. The CFD broker may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn’t include commissions or other fees. Thus, the CFD trader ends up with more money in their pocket.

What is CFD Leverage?

Unlike traditional dealing, CFD trading enables you to trade the markets by paying just a small fraction of the total trade value.

CFD Trading Leverage Example: Barclays

In conventional dealing, you would have to pay your broker the total value of the shares you wish to purchase. Say you wished to purchase 10,000 Barclays shares and the current value of its shares is 160p. You would have to pay the total value of the shares purchased, i.e. £16,000 (10,000 x 160p).

When you trade CFDs, you are trading on leverage, this means that you only have to deposit a small percentage of the total trade value to gain a similar level of exposure to the markets.

For example, if the margin rate for Barclays for retail traders is 20% of the total trade value, you would need to only deposit an initial £3,200 plus commission to trade the same £16,000 exposure. Professional traders with City Index would require margin of 3%

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For Retail Clients: This is worked out as (10,000 x 160p x 20%) = £3,200 initial stake.

For Professional Clients: This is worked out as (10,000 x 160p x 3%) = £480 initial stake.

For retail clients, our share margins are typically 20% on our most popular shares whilst our margins for Indices CFDs such as the UK 100 and Wall Street start at just 5%. Our margins for major currency CFDs start at 3.33%, and commodity CFDs start from just 10%.

For professional clients our share margins are typically 3% on our most popular shares whilst our margins for Indices CFDs such as the UK 100 and Wall Street start at just 0.25%. Our margins for major currency CFDs start at 0.25%, and commodity CFDs start from just 0.5%.

Please be aware that some CFD contracts incur a small overnight financing charge. Find out more about our financing and charges.

Example of gains

By only having to deposit a small fraction of the total trade value whilst maintaining a full exposure, you can magnify your gains.In the above leverage example, you only need to make an initial deposit of £3,200 plus commission whilst maintaining a total exposure of £16,000. Were Barclays’ share price to rally 10% in your favour, you would net a profit of £1,600. This represents a return on investment of 50% even though the share price has only moved 10%.

Magnifying your losses

As with all forms of financial trading, there is the potential to lose all or part of your investment. The key risk with leverage is that it can magnify your losses in exactly the same way as your gains. If the Barclays share price had moved against you falling to a new price of 144p, your position would now be worth £14,400 resulting in a £1600 net loss. This represents a return on investment of -50% as the share price has dropped 10%. Your City Index CFD trading account includes a range of risk management tools to help you manage your risk. Find out more about CFD trading risks.

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