Is my understanding of CFD trading correct?

Adelais

Newbie
2 1
Hi there,

I've been reading quite a bit about CFDs and CFD trading and here is my understanding of the concept. I just wanted to confirm what I've understood is really what CFD trading is!

- In a nutshell, when someone trades CFDs, they trade nothing, no underlying asset or anything. Zilch. They are simply betting whether the price of a stock will go up or down. For example, the stock price for a share of Company A is £1. Mr. Z decides to buy 1000 shares of Company A for £1000. So he does so via a traditional broker.

Now comes Mr. Y. He wants to buy the same amount of shares, but he doesn't have the money. So instead of paying £1000, he goes to a CFD provider who provide him with 1000 imaginary shares of company A for only £20 at a 2% margin.

If stock price for one share of company A goes up by 2%, then MR. Z makes £20 worth of profit.

In the case of MR. Y, he too makes £20 worth of profit - albeit with a lower initial investment.

However, in the case of the price of stock falling by 10% - then MR. Z looses £100 of his £1000. Whereas MR Y looses his £20 and would have to pay £80 to the CFD trader.

Here is where I get a bit confused: why does MR.Y have to pay £80 to the CFD provider? I mean is it's not as if the CFD provider went out of their way to actually buy the underlying stock? They don't even need to have the ability to buy the actual stock - they just need to assure MR. Y that, for a 2% margin, his £20 has the same purchasing power that Mr. Z's £1000 has. Therefore, his trade should simply close once the price of Company A has fallen by 2%.

To put things in another term: my friend tells me that she only has £20 but wants 1000 shares of company A as she believes the share price will go up. So I tell her, you can't afford 1000 shares with £20, but if you give me £20, I will make sure that you get the profit that you'd make as if you had 1000 shares. So price goes up by 1%, she closes this imaginary trade and I give her £20 profit. But if her bet goes against her, I don't actually have to charge her £80 extra for her being wrong? I won't even have to keep her £20? I only need to have the ability to pay her the profit.

Am I making any sense, or have I misunderstood something?

Also, I do understand that there is a buy and a sell price for CFD stock. Where exactly is the sell price coming from? The buy price can easily be the price of the stock, but where exactly the sell price is coming from? For currencies I suppose this is the exchange rate of one currency against another, but what about for stock?

And speaking of currencies, can they only be traded on CFD provider platforms? Apart from obviously going out and for instance buying euros with pound, hoping that in the future the price of euro will go up against pound, allowing for profit to be made.

And one more thing: Company A has only 2 publicly available stocks. In a traditional sense, this means only 2 individuals can own the stocks. Whereas in CFD trading there is no limit to the number of people who can trade CFDs for this asset as nothing is actually being purchased, right?

Sorry about the long post!
I'd really appreciate your help.
 
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J_C_Anderson

Active member
126 21
Yeah, it all works just as you described.
But, is the stock price falls low enough, the CFD provider would close your position.
For examle, the position will be closed after loosing 80% of it`s initial value (£16).
That is why there are only CFD`s on "slow" enough stocks, so the provider might be sure that there would be no such situations.

CFD`s price is calculated using underlying (the stock itself) price.
 

Adelais

Newbie
2 1
Thanks for the replies. I've been just trying to get my head around what I started to get myself into a few years ago.

For now I think I will stay off the derivative markets and mainly concentrate on the more traditional ones - buying shares etc.

I've become quite interested in day-trading stocks - but I'm at the initial stages, so...might take me a bit of time to get my head around that one.
 

PPino

Newbie
1 0
As for me, I started to trade CFDs and had to learn everything myself from zero. So, I would recommend to read some guides and useful resources to understand it better. Who is interested, check this one https://capital.com/what-is-cfd-trading There are also webinars, I watch from time to time when I can
 

Akinozragore

Junior member
43 4
Yep, in general, you've got the essence of CFD right. Important nuance - you cannot be in red while CFD trading. Even with 20 pounds capital with the up to 100 pounds. As far as J_C_Anderson concerned, the broker will take care of the capital protection at the level of 80%.
Despite CFD is basically a betting, it has its own advantages. In some (developed) countries CFD helps to save on taxes, in other (developing) - it is the only way at least somehow to invest in stocks of the European and American companies. If you have substantial capital and don't care about taxes - then you can just invest in the regular stocks and don't fend for yourself. But if you start with small numbers, CFD gives much more opportunities.
In this, the fact that you don't own physical shares is not an issue, if you are trading through the reliable broker. After all, your profit is the only thing which matters :)
 

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