How to Trade CFDs


CFD Trading is the derivative trading method of choice in many countries around the world (although in the UK and Ireland, for example, Spread Betting is more popular).

Let’s take a closer look at an example of how a CFD trade operates:

CFD Trade Example

CFD_Trading

CFD Trade Example

CFD Trade Example

Here we give an example of a CFD trade using the widely traded FTSE 100 index:

Let’s say that the FTSE is currently trading at a level of 7004.4/7005.4. A trader has the choice to either sell the FTSE index at the 7004.4 level, or buy at 7005.4. The trader in our example decides to buy £5 of the FTSE.

Before proceeding with the trade, the trader would like to calculate the nominal risk. This is the maximum loss this trader could incur if the FTSE 100 dropped from its current 7005.4 level to zero.

To calculate nominal risk: Level security is purchased at x amount bought (£)

Therefore, if the FTSE did decline from its current level to zero, the trader would incur a loss of £35,027 (7005.4 x £5).

How to calculate leverage

How to calculate leverage

How to calculate leverage

Rather than depositing the total cost of the trade, which would have been the same cost as the trader’s nominal risk at £35,027, the leverage offered with CFDs means that a trader is only required to deposit a fraction of this overall cost to open the trade.

Leverage is calculated as a percentage of the nominal risk. For example, if the margin was 1%, the leverage would be £350.27 (£35,027/100). This means £350.27 would be required to initiate the trade.

On the other hand, if the FTSE is currently trading at a level of 7004.4/7005.4 and the trader chose to sell £5 of the FTSE 100 instead of buying it, the price of the trade would be £35,022 (7004.4 x £5). The deposit the trader would need to open the trade would be 1% of this price, £350.22 (£35,022/100).

Traders are advised to remember that although increasing leverage has the potential to magnify gains, it also magnifies the risk of losses.

Calculating profits for CFDs

Calculating profits for CFDs

Calculating profits for CFDs

Returning to the case study where our trader bought £5 of the FTSE 100, if the FTSE index proceeded to see an increase to a level of 7007.4/7008.4, the trader  may decide it would be a good time to close this position. To calculate the profit on the trade:

Profit made =  amount bought (£) x number of points the trade has moved in trader’s favour

In this case, the trader’s profit would be £10 (£5 x 2).

In the other direction, if the trader had decided to sell £5 of the FTSE 100 at the 7004.4 level and then closed the trade at that 7007.4/7008.4 level, the loss on the trade would be £20 (£5 x 4), as the price of the closing trade is four points more than when it was opened.

In another instance, the FTSE 100 declines from 7004.4/7005.4 to7002.4/7003.4. If the trader had opened the trade by purchasing £5 of the FTSE 100, were the trader to sell at the new level, this would result in a loss:

Loss incurred = amount bought x number of points the trade has moved against trader’s favour

The trader’s loss would be £15 (£5 x 3).

If the trader had instead sold £5 of the FTSE 100 at the original level then the profit would be £5 (£5x1).

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