How does CFD Finance really work?
CFD finance is relatively simple to understand, if you understand the entire CFD trading process. When you buy a contract for difference, you only need to provide a small margin. This margin requirement is necessary to cover any losses you may have on a position and changes from day to day as the value of the underlying position changes. The small margin you pay does not cover the cost of the underlying instrument. To hedge your position, the broker will buy the underlying stock when you enter a position, and to do so you have to pay the full purchase price. In effect, the broker is lending you the cash while keeping the position open.
Buying CFDs
When you buy a CFD, the broker will charge you interest on the money. The interest rate is applied to the nominal value of the position, that is, the number of contracts multiplied by the current price. So if you buy 1000 BHP contracts at $33, you will need to pay interest on $33,000. This is how CFD financing works when you go long.
Sell CFDs
On the other side of the coin, if you short a CFD, you effectively receive the cash for that sale. While it doesn’t end up in your bank account, it does end up in the brokers’ bank account if they sell the underlying stock. So selling 1,000 CBA contracts at $33 would mean you would receive interest on $33,000. This is how CFD financing works when short trading.
How much will it cost?
Interest rates vary from provider to provider, but are generally based on the following formula. A reference interest rate plus a margin of 2 – 3% for long positions and a reference interest rate minus a margin of 2 – 3% when trading short. The benchmark rates used are usually the Reserve Bank of Australia (RBA) rate or the London Interbank Offered Rate (LIBOR). Therefore, the broker is making money on the interest margin he takes on each position. This is how CFD finance works for them and CFDs could be considered a sophisticated way of lending money.
How are CFD finance charges calculated?
Interest charges are calculated daily and do not apply to positions opened and closed on the same day. Therefore, intraday trades are interest-free, while overnight trades will incur charges. CFD financing does not apply to intraday positions. When trading CFDs, the impact of finance costs is minimal as interest rates are currently around 6% per annum, while CFD positions can easily fluctuate by 6% in a day.
