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How Margin Works When Trading CFDs
by: Mike Estrey

One of the major benefits of stockmarket trading using CFDs is the ability to leverage investments by using margin.

What this means is that for a small deposit, a trader can have access to a significant amount of open positions, and this has the effect of magnifying gains and losses in relation to the margin required.

As an example, a trade in one of the UK’s leading blue chip companies might require an initial margin of 5%. This simply means that if you were to open a position to the value of say £10,000, your account would require an initial margin of just £500.

Any gains and losses you consequently make in this example will be magnified by twenty times, which can make for spectacular profits, but also substantial losses.

The effect of margin

Unlike an ordinary share deal, using margin means that you can lose more than you invest. You do, however, have the ability to protect yourself using stop losses and it is recommended that you set these for each trade.

If you were to lose more than your initial margin payment in a single day you would be liable to pay the difference to the CFD broker.

If the loss is more gradual you are required to keep the margin topped up to the minimum required percentage or close some of your positions to reduce the margin requirement.

If you fail to make prompt margin payments, part or all of your position may be closed by the CFD broker and losses could again exceed your initial margin.

Profits on open positions are credited to your account daily and losses are deducted, and this amount is called variation margin.

The costs involved

If you are buying a share, index or other commodity, which is also known as “opening a long position” or “going long”, you are effectively borrowing the money from the bank for the period the trade is open. You therefore pay interest until the position is closed.

If you are selling (“opening a short position” or “going short”) with the intention of buying back later, you consequently receive interest until the position is closed. Please note there is a difference between the percentage interest charged on long positions and the percentage interest received on short positions.

Together with any commissions for opening and closing the trade, there are no other costs for opening a CFD position using margin.

A worked example

In the following example, we show a traditional stockbroking deal with costs and compare it to the equivalent trade using CFDs.

Traditional deal: Opening Trade – buy 5000 HBOS shares

Buying Price - 900p
Gross Cost - 45000.00
Stamp Duty - 225.00
Commission @ 0.5% - 225.00
Net Cost - 45450.00

Closing Trade – ten days later

Selling Price - 920p
Gross Proceeds - 46000.00
Commission @ 0.5% - 230.00
Net Proceeds - 45770.00
Overall Profit and Return on Capital Invested - 320.00 (0.71%)

CFD DEAL

Gross Cost - 45000.00
Commission @ 0.5% and no stamp duty - 225.00
Net Cost - 45225.00
Margin required (5%) - 2261.25

Gross Profit - 46000.00
Commission @ 0.5% - 230.00
Financing Costs (10 days @ 8.5% p.a.) - 105.32
Net Proceeds - 45664.68
Overall Profit and Return on Capital Invested - 439.68 (19.44%)

What happens each evening is that the accrued profits or losses at the end of the day, when the position is ‘marked to market’, are added or subtracted from the initial margin.

After the position is closed, the initial margin is credited back to the client and the profit or loss simply represents the sum of the variable margin for the time it was open.

Profits and losses are magnified using CFDs. By using the benefits of leverage, a small deposit enables big profits to be made – in this example the return on capital was almost 20% in just two weeks.

Of course, if the price had moved the opposite way the loss relative to the deposit would be magnified accordingly, and it is possible for you to lose more than your initial deposit.

The margin required fluctuates in response to movements in the underlying price. At times, you may be required to place further funds on deposit, especially in times when market conditions are exceptionally volatile, as margin rates can be raised by the CFD broker.

How to work out the interest cost on long positions

In this example, a CFD trader buys (“goes long”) 10000 shares of Vodafone at a price of 170.25p. The notional total value of this position is 10000 x 1.7025 = £17025.

One night’s interest would be £17025 x 8.5% (prevailing interest rate plus 3%) divided by 365. This would equate to £3.96 interest debited each night while this position remains open.

A word of warning

Trading in these markets is generally considered to be suitable only for the more experienced investor as it carries a higher degree of risk than straightforward purchases of shares.

You should know how much you potentially can lose and honestly evaluate if you can afford to lose it in view of your financial resources and investment goals.

Changes in exchange rates may also cause your investment to go up or down in value and tax law may be subject to change, and if in any doubt, please seek further advice.

About The Author
Mike Estrey is the Head of Research for Blue Index, the Online CFD Trading Specialists. A free 15 day trial of their CFD Research is available, along with CFD Trading Seminars and Workshops. For more about visit http://www.blueindex.co.uk