Contracts for difference are popular products when the market is crashing or there's high volatility because traders can still profit if prices fall, although it comes with more risk than traditional investing.
Taking the long or short option is speculating on the values moving up or down. The difference in the long and short option is the potential loss or profit made on the trades. Read on to find out more.
Traders can speculate on the price movements of:
- Indices (e.g. ASX200)
- Individual stocks
- Commodities (e..g. gold or oil)
- Currencies (Forex)
Trading CFDs and forex on leverage is high-risk and you could lose more than your initial investment. It may not be suitable for every investor. Refer to the provider’s PDS and consider the risks before trading.
What is a contract for difference?
A contract for difference (CFD) is a particular form of contract between you (payer) and your broker (seller) based on the price of a particular asset. When the contract is signed, this price is called the "entry price", whereas at the end of the contract, it's called the "exit price".
See also: An indepth look at CFDs
If the exit price of a particular asset is higher than the entry price, the seller has to pay the difference to the buyer: this is called the "long position".
If the exit price is lower, the buyer has to pay the difference to the seller: this is called the "short position". That’s why it’s called a "contract for difference". It’s based on the prices and the buyer does not get any right over the asset.
Examples of assets can be shares indexes, shares and commodities such as gold or oil.
CFDs are normally purchased on a margin basis: every financial derivative has its own percentage. The margin can identified as a deposit for the purchase of the particular asset. If you buy 100 shares at $5 each and the margin is 5%, you will pay $5 x 100 x 5% which equals to $25. There’s also the opportunity to take advantage of leverage.
Taking the long position
The long position means the trader expects the value of the security or asset in question to increase.
For example, you take a position in stock XYZ trades at $10 and an increase is expected. You have $10,000 and the initial margin is 10%, it's the equivalent of purchasing 10,000 shares (calculated as follows: $10,000/$10 = 1,000 shares divided per 10% = 10,000). Let’s assume that in two weeks the stock price increases to $5.10 at the CFD close-out. This means you will have profited by $1,000. However, in this situation you are assuming the market moves in your favour. Trading CFDs involves risk, especially for those who are not familiar with the underlying assets they are trading. Due to trading with leverage, it is possible to lose more than your initial capital if the market goes down when you've traded on it going up.
Please keep in mind that this is gross profit and that you have to subtract the cost of the trade being open for two weeks and also the trading commissions due. At the end of this calculation you will get the net profit from the long position.
The short position when prices fall
When the short position is discussed, the trader expects the value of the security, index, commodity or currency in question to decrease. An example is if the XYZ stock trades at $10 and a decrease is expected.
If the investment is $10,000 of funding and the margin is initially 10%, in order to gain a profit you need to sell the shares and then re-buy later on. You will sell 10,000 shares.
Let’s assume that the stock decreases to $9.75 in a couple of weeks, the 10% is covered and the stock has depreciated. This time you will get $2,500 of profit. As mentioned in the previous case, this is gross profit. Its also important to point out the market could move up instead of down. Although the flip side is also true. If the market goes up and you've traded against the market, you could lose more than your initial investment.
This time you need to add the amount of interest received for the two weeks when the position is open. The net profit will be calculated as follows: gross profit plus interests minus trading commission.
What’s the difference?
The difference between the long and short positions lies basically in the interest rate that has to be subtracted from the gross profit in the case of the long position and added in the case of the short position.
Here you can see an example on how the long and short positions work:
|Leverage (margin)||10:1 (10%)||10:1 (10%)|
|Fee CFD Position (open)||$150||$150|
|Fee CFD Position (closed)||$160||$140|
|Profit - gross||$10,000||$10,000|
|Interest subtracted (long)||$257||-|
|Interest added (short)||-||$235|
|Profit - net||$9,433||$9,945|
In this particular case you could make a higher profit from the short position because of the "interest" factor.
Let’s assume that in both cases you get a loss. In the long position you have to add the interest, while in the short position you need to subtract the interest. In such cases going long will minimise the loss, whereas going short will increase the loss.
Using leverage could also boost your profits as much as your losses: it would be better to limit this financial tool if you are a newbie.
As always, it is important to think about the risks involved
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades. Read the Product Disclosure Statement (PDS) and Target Market Determination (TMD) for the product on the provider's website.