CFD Tutorial: How CFD Trading Works

Let’s go through an example CFD trade, as this is best way to learn about how CFDs work.

Let’s say that we have a leveraged up to $100 000.

The cash float required to trade this leverage amount, depending on how much leverage you use, could be less than $100 000. If the provider allows 2 to 1 leverage, then the amount required is $50 000, if 5 to 1 leverage then it is $20 000, and so on.

Note that leverage multiplies your trading results. So using high leverage can increase both gains and losses in a trading system, and thus should be used with responsibility and care.

And let’s say that for our trading system, that we want to use a fixed trade size of $10 000 per trade. Thus we can be in a maximum of 10 positions at the same time, with our current float. This is an example for illustration purposes only, and this money management model may not be suitable for your system. So you will have to backtest and select your own money management rules.

Let’s say that you bought some CFDs when its price was $5.70.

With a trade size of $10 000, this means that the number of CFDs bought would have been 1754, that is 10 000/5.70 = 1754.

Note: this trade size is purely hypothetical and is not a recommendation of how to perform money management, or a part of any recommended system, and is for illustration purposes only.

And let’s say that our stop loss was set at $5.50, which means that if the price falls to or below $5.50, then we would exit this trade at a loss.

Let’s assume the trade goes well, and that the CFD price is now $5.90. And let’s say that we now trail our stop up to $5.65. A trailing stop is a stop that moves in the direction of our trade (up for long positions) as the trade goes in our direction.

The CFD price goes up to $6.32, and our trailing stop is moved up to $6.20. Then finally the CFD price falls, and in fact falls through the stop loss of $6.20, thus exiting us at $6.20.

The whole trade took 14 days.

The difference in the price from entry to exit = $6.20 - $5.70, which comes to $0.50.

Thus our gross profit = (difference between entry and exit price) x (number of CFDs)
= $0.50 x 1754
= $877.

So we've calculated our gross profit. Let’s now calculate our costs, to work out the net profit.

Our costs = commission + interest. Let's calculate each in turn:

1. Let’s assume our CFD provider’s commissions are $15 in and $15 out, or 0.15% of the trade size, whichever is greater. In this case, our commission would be:

Commission = $15 + $15 = $30

2. And let’s also assume that our provider’s interest rate charge for long positions held overnight is 7.5% or 0.075 per annum. To calculate how much this is for our trade, we need to make it “pro rata” (times it by the days in trade, then divide by 365), and then multiply it by the trade size.

Interest = (interest rate for long position) x (days in trade/365) x (trade size).
= 0.075 x 14/365 x 10000
= $28.76

Thus our net profit = gross profit - (commission + interest)
= $877 – (30 + 28.76)
= $818.24

Not that the above is a hypothetical trade and is not taken from any particular system.

So there you go, your first CFD trade in entirety.

Note here, that for short positions, interest costs are paid to you, not charged, so will offset rather than contribute to the costs. Also note that the exact figure for the interest payment is a bit more complex that the above example, as the interest is calculated daily from the value of the trade size at market value, rather than from the value of the trade size when entering or exiting the position. If we calculated the interest cost using the final position size of 10818.24, the interest would be $31.28, which is very similar. So the real interest cost would be between $28 and $31.

So that’s how a CFD trade is done. You have seen leverage at work, as well as how transaction costs are calculated for a CFD trade.

Note that the above example assumes no slippage, which means that you enter and exited at the intended price.

It is possible to for example exit at a price that is different to the intended price due to gapping or liquidity issues. For example, if your stop loss is at a certain price but the stock opens below that price, or trades at inadequate volume at the price, then your exit price may be lower than that intended.

This can occur at times and is known as slippage.

Find out more in part 2 on this CFD tutorial: CFD Position Sizing and the two most common models for position sizing.