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The contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR or some other interest rate benchmark e.g. Reserve Bank rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.
Traditionally, equity based CFDs are subject to a commission that is a percentage of the size of the position for each trade. Alternatively, a trader can opt to trade with a market maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument.
MarginTraders in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (usually ranging from 0.5% to 30%). One advantage to traders of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a substantial part of the assets.
CFDs allow a trader to go short or long on any position using margin. There are always two types of margin with a CFD trade -
1.Initial Margin - (normally between 3% and 30% for shares/stocks and 0.5% - 1% for indices, foreign exchange and commodities)
2.Variation Margin - (which is then 'marked to market').
Initial margin is fixed at between 0.5% and 30% depending on the underlying product and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility in the world's stockmarkets.
Many refer to initial margin as a deposit. For example, for large and highly liquid stocks such as Vodafone the initial margin will be nearer 3%, and depending on the broker and the client's relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher.
Variation margin is applied to positions if they move against a client. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £100 in variation margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in running profits.
Variation margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.
LeverageOne of the benefits (and risks) of trading CFDs is that they are traded on margin meaning that they provide the trader with leverage. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. The margin requirements on CFDs are low meaning that only small amount of money is required to take large positions.
Stop loss ordersA stop loss order can be set to trigger an exit point as pre-determined by the trader e.g. Buy at $3.00 with a stop loss at $2.60. Once the stop loss is triggered, a sell signal is activated to the CFD provider and actioned in accordance with their terms of business and taking into account available liquidity to action the request. DMA providers typically receive the stop loss value via the phone or online ordering and will place the order in the market to be actioned at the pre-determined price to a limited price range e.g. to a maximum 6c further,and providing there is matching liquidity. If the stop loss price is triggered and the price then rapidly moves outside the 6c range in this example, or there is insufficient liquidity for your order and considering other people that have orders at that price point, your stop loss sell order may not be triggered and you remain in the position.
