Let’s use a case study to illustrate how CFD’s (Contract’s For Difference) work. So lets take Australian listed Woodside Petroleum (WPL) and assume the price is at $50. After our technical or fundamental analysis we have decided whether we want to sell (going short) or buy (going long) the stock (or the CFD). Say we go long (buy the stock) and decide to risk $1 on each point of fluctuation in Woodside’s share price. (A point is worth a cent in this context) This means for every cent that the WPL shares move, the trader either gains or loses $1. Now the way you decide this $1 risk per point depends on the leverage (CFD dealers usually have a 3%, 5%, 10% or 20% options available on the amount of leverage) and the size of your contract with your CFD dealer. So if the WPL shares have gained 10 cents and want to take profits your profit would be 10 x 1 = $10 or if the share lost 10 cents then you lose $10.
So to take this example of how CFD’s work to the next level, still assuming the $50 underlying share price for WPL. Say we have $10,000 (ten thousand dollars) to invest in the trading game. Say if your CFD broker has a 5% margin required (the leverage amount) for WPL. 5% of $50 is $2.50 so you need to deposit at least $2.50 per share with your dealer to trade WPL CFDs. The reason why I say at least is because the shares may fluctuate since these CFDs are mark to market which means, at all times you trade CFDs you must maintain this 5% margin level or else the broker make liquidate your position. So with the $2.50 per share margin requirement you can buy 4,000 ($10,000/$2.50) shares or $200,000 worth of exposure to WPL. That’s the power of leverage. And remember – it’s a double edged sword.