Contract For Difference (CFD) are a new trading product in South Africa that give traders more trading power, flexibility and trading opportunities. Since the introduction of CFDs as a trading product in South Africa, they have become very popular.

This is a quick tutorial on how to trade CFDs to demonstrate just how easy trading is and why it is they are so popular. For those just getting started on CFD trading this tutorial will quickly get you up and running.

By the time you finish this article, you'll know how CFDs work, what makes them highly profitable, and understand the costs involved in CFD trading. To help get you started, you'll also be able to open a CFD trading account with R100 000 of virtual money where you can try trading CFDs in a simulator environment and try it out for yourself.

CFDs are a derivative product, where you profit from changes in the prices of stocks and shares.

For example, if you buy a CFD on a stock that's R100.00 and the pricerises to R120.00, then you profit from that change in price. So if youbought 1000 CFDs, then your profit is R2,000.00. That is, the value ofthe CFDs mirror the underlying stock prices, and you can profit on thismovement.

The reasons why CFDs are becoming so popular as a trading product include:

• Leverage - CFDs are traded on leverage, also called Gearing, and this leverage is typically 10 to 1. This means that a trader with a small float can make decent profits from trading the stock market by using CFDs. For example, you may have a stock trading system that makes a 20% return per annum. On a R20, 000 float, this is $4,000.00 profit in one year. With CFDs, because of the leverage, the same system can now produce a 200% return, which is R40,000.00 profit in one year.
• Long and Short - With CFDs you can enter both 'Long' and 'Short' positions. Meaning you can profit from rising and falling markets. This greatly increases the profitability of a trading system because trading opportunities increase dramatically, and the fact that you can profit from both bull and bear markets.
• Pairs Trading - Since you can go long and short with CFDs it is possible to engage in pairs trading to cancel out much of the market risk and trade on the difference between two stocks. For example, you can go long on MTN while going short on Telkom.
• Low costs - The costs in CFD trading are relatively low when compared to stocks and are not subject to Stamp Duty UST, VAT, Strate or other charges associated with trading on an exchange. This is especially so, since for a similar and often smaller cost per trade, you can gain 10 or greater times the results from a trade due to the leverage available. The 2 main costs in CFD trading are interest and leverage. We will come to these in a moment.
• Automatic Order Fills – Through the use of online trading platforms you can set automatic 'buy' and 'sell' orders. You can also create 'break orders', also called 'stop losses'. This means that it will take you less time to trade, remove some of the emotion from entering and exiting a trade when you should, and allow you to exit as the stop is hit, not a day later. You therefore significantly reduce and avoid the slippage due to getting out of a trade later than when you intended.
• 24 Hour Orders - You can place orders while the market is open or in the evenings while the market is closed. When the stock reaches your entry price, the order will be automatically filled by the trading platform. So you can plan and setup your position entry, exit and stop losses the night before and the system will do the rest. For people who are working, this is a great advantage as they can do all their trading (place their orders to enter and their stop losses) in the evenings, and not need to be at the computer screen or call their broker during the day. Also, if they have any stop losses that need adjusting, they can do so in the evenings as well. Their trading routine with a mechanical system can be about 10-15 minutes per day.

So these are the advantages of CFDs that have made trading accessibleto so many people because they provide large returns for a modestfloat, and can also be traded once a day as well.

Now, we mentioned that there are 2 main costs in CFD trading. Let's now take a closer at each:

• Commission – Brokers offering CFD platforms take a commission on every trade, there commission may be between 0.3% and 0.5% of the trade size, on entry and on exit. This means your total commission costs will be between 0.6% and 1.0% depending on your brokers commission rate. These costs are similar or less than the commission associated with stock trading, especially when you consider that the multiplied profits that the leverage gives you.
• Interest Charges - With CFDs, there's interest charged for long and short positions that are held overnight. For short positions, the interest is paid to you. The amount of interest charged is calculated in relation to the SAFEY reference rate. If you hold an overnight long position you are charged SAFEY + approximately 2%. If you hold an overnight short position you are paid interest, usually the same reference rate minus approximately 2% (SAFEY – 2%). For purpose of this tutorial we will assume SAFEY is at around 10.60% per anum or 0.106. On average around Prime -4%.

Let's look at a few examples of charges on overnight positions. We willstart with a long position held at SAFEY + 2%. To calculate how muchthis is for a trade, we need to make it "pro rata", in practice it iscalculated and charged daily. That is, we'd need to divide the 0.106 by365 days, multiply it buy the number of days in the trade, thenmultiply it by the trade size. For example, for a long trade with asize of R10,000.00, held for 7 days, the interest cost is about R20.33.Not a huge cost. For a short trade, the interest is paid to you, sowill offset the cost rather than contribute to it.

You now understand the benefits of trading CFDs and why they're atrading instrument that allows people with a modest float to make verydecent returns, as well as understand the costs involved with tradingCFDs.

Let’s go through a long and short CFD trade to show you CFD trading works.

By doing this, we will combine the principles such as leverage, transaction costs and position sizing  into practice.

Let’s begin with a float of R20,000.00 cash. Our broker can leverageour trades at a ratio of 10 to 1. So for every R1.00 we have we can buyR10.00 worth of shares , hence our leveraged up float is R200,000.00.

A Long Trade with CFDs

For simple sake we will enter a long position with R10,000.00 at aprice of R200.00. In this case we could buy 50 shares (10000/200).

Before we enter this trade we decide that we are prepared to lose only10% should the stock price go down and not up as we expect it to do.That's R1000.00. So we will be placing a stop loss (break order) atR180.00. So if the stock price goes down and we are at work or notwatching the screen, then the most we can lose is R1000.00. This is howwe protect and preserve our capital. Never, never, never enter a tradewithout knowing what you are prepared to lose. If our stop loss istriggered we will lose R20.00 per share.

Let's say that we’re in the trade and the CFD price is going up andreaches R220.00. What we will now do is amend our break order fromR180.00 to R200.00. If the stock now goes down, all we would lose isour commission and interest charges.

By day 7, the last day, our stock has reached a price of R220.00 andincrease of 10% and we want to exit the trade as we think the stock isabout to start going down. We sell the stock and exit spot on R220.00per share. We made a profit of R1000.00 (50 shares * 20), or did we?

We have not calculated our commission and interest charges which, ifour broker charges 0.5% and SAFEY + 2 would mean we need to pay 1%commission (entry and exit) + 12.6%. When we entered we usedR10,000.00, when we sold we exited at R11,000.00 our commission chargeis therefore R50.00 + R55.00 = 105.00. Leaving us with R895.00 profit.Earlier we calculated the overnight costs on a similar position for7-days and found the cost was R20.33. But we need to factor in ourprofit so we must use R11,000.00 as the position size. The interestcharge comes to R22.36. So we can deduct this cost from our profit tobe left with R872.64. Not bad for 7 days.

Now let's reverse this trade and say that we think the stock will go down and we are going to short the CFD.

A Short Trade with CFDs

We will enter a short position with R10,000.00 at a price of R200.00.In this case we could buy 50 shares (10000/200). Same as before. Norocket science there.

Before we enter this trade we decide that we are prepared to lose only10% should the stock price go up and not down as we expect it to do.That's R1000.00. So we will be placing a stop loss (break order) atR220.00 to buy back and cover the shares we sold without owning them.So if the stock price goes up and we are at work or not watching thescreen, then the most we can lose is R1000.00. If our stop loss istriggered we will lose R20.00 per share.

Let's say that we’re in the trade and the CFD price is going down as wewish. It reaches R180.00. What we will now do is amend our break orderfrom R220.00 down to R200.00. If the stock now goes up, all we wouldlose is our commission and interest charges.

By day 7, the last day, our stock has reached a price of R180.00 anddecrease of 10% and we want to exit the trade as we think the stock isabout to turn around start going up. We buy the stock, so covering thestock we did not own when we sold it, and exit spot on R180.00 pershare. We made a profit of R1000.00 (50 shares * 20), or did we?

We have not calculated our commission and interest charges which, ifour broker charges 0.5% and SAFEY - 2 would mean we need to pay 1%commission (entry and exit) + 9.5%. When we entered we used R10,000.00,when we sold we exited at R11,000.00 our commission charge is thereforeR50.00 + R55.00 = 105.00. Leaving us with R895.00 profit. So far theresult looks the same as our long trade example. Now here is where itis different.

Remember that for short positions, interest is paid to you, notcharged, so will offset rather than contribute to the costs. Alsorealise that in this example, the interest charge is slightlysimplified because the interest for CFD providers is usually calculatedon the market value of the trade position on a daily basis. If we didcalculate the interest cost using the final position size ofR11,000.00, the interest would be R11.68.

That's it you have gone through an entire CFD trade. Excellent work.

The margin needed for the trade was R1000. The return on investment, orROI, as a percentage of margin used, is therefore 100% (ROI = 1000 profit/1000 margin = 1 * 100).

If you want to get started trading CFDs, click here now to open a simulated trading account .