Part 3 - How do share CFDs work?

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A share CFD is an undated contract that captures every aspect of share trading. You trade at the underlying market price, but you don't actually own the shares and do not have to put up the full contract value.

The CFD provider quotes a two-way price - a bid price and offer price (eg BP 468/468.5). You buy at the top end if you think the market will rise, or sell at the bottom end if you think it will fall.

To open your trade, you do not need to pay the full amount for the position. You trade on margin, a deposit usually starting at 5% for equities, and pay a small commission of typically 0.10% per transaction.

So, say you read on Interactive Investor that transport operator FirstGroup (FGP) is considering handing back the £1.1 billion First Great Western rail contract three years ahead of schedule as the economic downturn threatens the viability of the franchise. The discussion boards are awash with reports that such a move would save the company upwards of £800 million and have a positive effect on the company's share price.

As you think the company's share price will rise you decide to take a long CFD position. Your CFD provider is quoting a price of 344/344.5.

Step 1 Opening a position

You buy 5,000 FirstGroup CFDs at the offer price.

5,000 x 344.5p = £17,225

Margin requirement is open position x margin percentage. Typical margin for equities is 5% depending on the liquidity of the underlying instrument. In this example FirstGroup CFDs require margin of 5%.

£17,225 x 0.05 = £861.25

You get charged commission of 0.1% on this transaction.

£17,225 x 0.001 = £17.22

Step 2 Closing the position

A week later, the FirstGroup share price has risen by 20p a share. The trade has moved in your favour and you decide to close the position and take a profit.

Your CFD provider is quoting a spread of 364.5/365.

You sell 5,000 FirstGroup CFDs at the bid price.

5,000 x 364.5 = £18,225

The position is now closed and so margin requirement is now zero.

You get charged commission of 0.1% on this transaction.

£18,225 x 0.001 = £18,22

Gross profit is the difference between opening position and closing the position.

£18,225 - £17,225 = £1,000

Net profit is gross profit less costs. The costs are the commissions you have had to pay to open and close the trade.

£17.22 + £18,22 = £35.44

The difference between the gross profit and the cost of the trade is £964.56. In summary, you had to deposit £861.25 to cover margin on this trade and made a profit of £964.56. If the price of FirstGroup shares had instead dropped by 20p in the week you held the shares you would, of course, have lost the same amount

Share CFDs have no fixed expiry date, so you can close your position whenever you like. While your position remains open, however, your account will be debited or credited to reflect interest and dividend adjustments.

In the inverse scenario what goes up can also go down.

You buy 5,000 FirstGroup CFDs at the offer price.

5,000 x 344.5p = £17,225

5% margin is £17,225 x 0.05 = £861.25

0.1% commission £17,225 x 0.001 = £17.22

Shares in FirstGroup fall 20p to 324.5/325

You decide to cut your losses

You sell 5,000 FirstGroup CFDs at the bid price.

5,000 x 324.5 = £16,225

0.1% commission is now £16,225 x 0.001 = £16.22

Gross loss is difference between opening position and closing the position.

£17,225 - £16,225 = £1,000

Net loss is gross loss plus costs. The costs are the commissions you have had to pay to open and close the trade.

£17.22 + £16,22 = £33.44

Net loss therefore is £1,033.44