Understanding CFDs: Risks of Leverage & Trading Costs | Ultima Markets

Understanding CFDs: Risks of Leverage and Trading Costs (Ultimate guide on CFDs)

Contracts for difference, simply CFDs, are financial derivative instruments. It is a contract between an investor or a trader and a broker, where the investor pays the difference in settlement price between the opening and closing of a trade.

What are CFDs?

CFDs allow traders to speculate on the price of the underlying asset. Traders do not own the underlying assets; they only trade the brokers' derivative contracts. These derivatives allow traders to take long and short positions, meaning they can benefit from market movements in both bull and bear markets.

These instruments are also versatile, as brokers offer CFDs of various asset classes which are legally permitted. The asset classes traded as CFDs are:

• Forex pairs
• Indices
• Commodities
• Shares
• Exchange-traded funds (ETFs)
• Cryptocurrencies and more

(It is to be noted that several regulators restrict the offering of risky asset classes to retail traders. For instance, the regulator in the United Kingdom does not allow brokers to offer cryptocurrency CFDs to retail traders.)

Most spot CFDs, including shares and indices, do not have an expiry date, meaning the position remains open until the trader closes them. However, some commodities CFDs and futures CFDs might have expert data.

Advantages of CFDs

CFDs bring many advantages to traders over other derivative classes or even physical trading. The key benefits of CFD trading are:

Access to leverage: One of the primary advantages of trading CFDs is access to leverage. Traders only need a fraction of the full value of the open positions as margin capital, and profit and loss are calculated based on the full value of the open positions. However, trading with leverage is very risky (leverage is discussed in a later section).

Long and short positions: Another advantage of trading CFDs is taking long or short market positions. As a trader, you can open a long position (trade at the buy price of the CFD contract) if you speculate the underlying asset price will increase. However, you can also open a short position (trade at the sell the CFD contract) if you speculate the underlying asset will go down.

Low entry barrier: CFD traders require a much lower initial capital margin than other derivatives like options and futures, while the minimum position size is also lower. Thus, the entry barrier to training for new and novice traders is significantly low.

Access to a broad range of markets: CFD brokers usually offer these derivative contracts for various asset classes. Popularised for trading forex pairs, commodities, and shares, traders can also access cryptocurrency CFDs (some jurisdictions restrict crypto CFDs to retail investors because they are too risky).

No delivery of the assets: CFDs are cash-settled instruments. Thus, traders do not need to worry about taking delivery of the underlying assets when the positions are closed.

Risks of trading CFDs

Despite their benefits, CFDs are complex and risky derivative instruments. Although the possibility of heightened gains from CFD trading can lure newbie investors, they must first understand the risks thoroughly.

Leverage can be dangerous: Leverage is one of the most significant selling points that attracts traders to CFD trading. However, traders must understand leverage properly, or they might risk losing their entire capital quickly.

Counterparty risks are there: CFDs are OTC instruments, making the broker the counterparty to the traders. Although many brokers often pass the risks of sending the orders to liquidity providers (a practice known as A-booking), some take opposite positions to the traders' open positions, a model known as B-booking. In the B-booking model, the broker makes money when the traders lose money.

Regulations can be tricky: CFDs are heavily regulated instruments. Many regulators, including those in the United Kingdom, European Union, and Australia, imposed heavy restrictions on the leverage and marketing offered by CFD brokers within their jurisdictions.

The United States and Belgium prohibit CFD trading. There is also a de facto ban on CFDs in Hong Kong as the jurisdiction’s gambling law prohibits the distribution of such derivatives unless regulated by the regulator, which only allows the trading of exchange-traded CFDs.

Understanding Leverage and Margin

Leverage is one of the primary advantages of trading CFDs, but it can be hazardous. With leverage, traders only need to raise a fraction of the capital required to take a prominent position in the market.

Leverage is expressed in ratios like 100:1, 50:1, 30:1, and 10:1. In the case of a 100:1 leverage ratio, traders only need to come up with a capital of $100 to take a position of $100,000 (100x of the initial value), while for 10:1, the capital requirement for a $100,000 position is $1,000 (10x of the initial value).

With leverage, traders can significantly increase their profitability from a trade. However, it can also magnify loss if the market moves against the position taken and can potentially exceed the initial investment. Many regulators mandate negative balance protection, meaning if the leveraged loss of an account exceeds the deposited capital, the positions in loss will be closed automatically.

An example of leverage in CFD trading:

You have decided to trade a CFD on the EUR/USD currency pair. You believe the price will rise, and your broker offers leverage of 30:1, meaning you only need to deposit 3.33% of the trade’s total value as a margin.

• Trade Size: $10,000
• Margin Required: $10,000 ÷ 30 = $333.33

With a deposit of just $333.33, you can take a $10,000 position. This leverage can significantly impact the trade's outcome (profit and loss).

Scenario 1: The trade goes in your favour

• If the EUR/USD price increases by 1%, you make $100 (1% of $10,000).
• Profit: $100 ÷ $333.33 = 30% return on your margin.

While this gain is impressive for such a small initial deposit, leverage works both ways.

Scenario 2: The trade moves against you

• If the EUR/USD price decreases by 1%, you lose $100 (1% of $10,000).
• Loss: $100 ÷ $333.33 = 30% of your margin lost.

You would lose your entire $333.33 margin if the EUR/USD pair drops 3.33%.

The offered leverage also varies with the underlying CFD assets. Usually, major forex pair CFDs have the highest leverage, while crypto CFDs (due to their volatility) have the lowest.

Trading costs of CFDs

Trading costs for derivatives are complicated compared to cash equities. Knowing these costs is crucial for CFD traders, as they might affect the overall trade outcome (profit or loss).

The following categories can classify CFD trading costs:

• Spreads
• Commissions
• Overnight fees
• Market data fees

Spreads

Spread is the difference between a CFD instrument's buying and selling prices. It is also called a bid-ask spread (bid is the selling price of an instrument, while ask is the buying price) and is often the primary revenue source of CFD brokers.

Brokers often market their services using the terms tight and wide spreads. A tight spread implies a small gap between bid and ask prices, while a widespread means the difference is higher.

An example of spread in CFD trading:

Let’s say you’re trading a CFD on gold. Your broker shows the following prices:

• Bid price: $1,980
• Ask price: $1,981

So the spread is: $1,981 - $1,980 = $1

Spreads can significantly impact the profitability of the trade.

How the spread can affect your trade:

1. When you open a trade
2. Let’s say you believe the price of gold will rise, so you open a buy position (go long) at the ask price of $1,981.
3. As soon as you enter the trade, your position is valued at the bid price of $1,980.
4. You start with an unrealised loss equal to the spread: $1.
5. When the price moves
6. If the gold price rises to $1,990 (bid) and $1,991 (ask), you can now close your trade by selling at the bid price of $1,990.
7. Your profit would be:
8. $1,990 (bid) - $1,981 (ask) = $9 profit (after covering the spread).

The trade outcome will also depend on whether the spreads are tight or wide.

• Tight spread: If the spread is $0.10 instead of $1, your cost to open the trade is significantly lower, and you break even faster.
• Wide spread: If the spread is $5, you need a larger price movement in your favour just to cover the cost of the trade.

Commissions

Shares CFD trading typically comes with associated commissions. Many brokers charge a commission on the entry and exit of a trade, which is either calculated as a fixed or variable cost to the position's value.

An example of commission in CFD trading:

Let’s say you have decided to trade a CFD on Apple shares. The broker charges a 0.1% commission per trade (both opening and closing positions).

If you want to buy 50 shares, the current price of Apple shares is $150 per share, the commission can be calculated as:

1. Trade size:
2. 50 shares × $150 = $7,500
3. Opening commission:
4. 0.1% × $7,500 = $7.50
5. Closing commission:
6. When you sell the shares to close the position, the same 0.1% commission applies. If the price remains at $150 per share:
7. 0.1% × $7,500 = $7.50
8. Total commission cost:
9. $7.50 (opening) + $7.50 (closing) = $15.00

The commission charged by the CFD broker can also significantly impact the trade outcome (profit and loss).

Suppose the Apple share price rises to $155 per share, and you decide to close the position.

1. New trade value:
2. 50 shares × $155 = $7,750
3. Profit before the commission:
4. $7,750 - $7,500 = $250
5. Profit after commission:
6. $250 - $15 (total commission) = $235

Understanding commissions is very crucial for traders. Commissions can impact traders in many ways:

• Impact on small trades: Commissions can significantly reduce profits for smaller trade sizes. For example, a small trade might barely cover the commission cost if the price doesn’t move much.
• Frequent trading costs: If you open and close positions frequently, commissions can add up quickly, eating into your profits.
• Comparison with spreads: Some brokers might offer commission-free share CFDs with wider spreads, while others charge tighter spreads with a commission. It’s important to calculate which structure works best for you.

Overnight fees

Overnight fees (also called swap fees or rollover costs) are charges applied when a CFD position remains open after the trading day ends (usually at 5 pm New York time). These fees cover the cost of leveraging the position, as the broker essentially lends you money to maintain your trade.

The overnight fee depends on the following:

1. The size of your position.
2. The broker’s financing rate.
3. The direction of the trade:
4. Long positions (buying) incur a cost.
5. Short positions (selling) might either incur a fee or earn a small credit, depending on the asset and market rates.

(H3) How to calculate overnight fees

The formula to calculate overnight fees is typically:

Overnight Fee = (Trade Size × Financing Rate) ÷ 365

• Trade size: The total value of the CFD position.
• Financing rate: Derived from a benchmark interest rate (e.g. the central bank rate) plus or minus the broker's markup.

Example 1: Overnight fee for a long position

Suppose you open a long CFD position on the FTSE 100 index with the following details:

• Trade size: £10,000
• Leverage: 20:1 (Margin: £500)
• Daily financing rate: 4.5% per annum.

Step 1: Calculate daily cost

1. Annual financing cost:
2. £10,000 × 4.5% = £450/year
3. Daily cost:
4. £450 ÷ 365 = £1.23 per day

Step 2: Apply the fee

• If you hold the position for 7 days, the total overnight fee would be:
• £1.23 × 7 = £8.61

Example 2: Overnight fee for a short position

Now, consider a short CFD position on EUR/USD:

• Trade size: $20,000
• Leverage: 30:1 (Margin: $666.67)
• Daily financing rate: -2.5% per annum (you earn a credit).

Step 1: Calculate daily credit

1. Annual financing credit:
2. $20,000 × -2.5% = -$500/year
3. Daily credit:
4. -$500 ÷ 365 = -$1.37 per day

Step 2: Apply the credit

• If you hold the position for 10 days, the total credit earned would be:
• -$1.37 × 10 = -$13.70

Market data fees

CFD brokers often charge a sum to offer real-time or delayed access to market price information for underlying assets, called market data fees. These fees are generally associated with the licensing costs to source the data from the exchange or other data feed providers.

Brokers usually charge market data fees monthly or annually.

Trade CFDs with Ultima Markets

Ultima Markets is a fully licensed broker offering access to 250+ financial instruments, including currency pairs, precious metals, crude oil, indices, shares, and cryptos. We provide a high leverage ratio of up to 2000:1 and guarantee tight spreads and fast execution. Our pricing is also transparent to help traders determine the trading costs ahead.

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