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CFDs: Going long vs shorting the market
This guide will help you understand the concept of going long vs going short with Contract for Differences (CFD).
Contracts for difference are popular products when the market is crashing or there’s high volatility because traders can still profit if prices fall.
Taking the long or short option is betting on the values moving up or down. The difference in the long and short option is the potential loss or profit made on the trades. Read on to find out more.
Traders can bet on the price movements of:
- Indices (e.g. NZX50)
- Individual stocks
- Commodities (e..g. gold or oil)
- Currencies (Forex)
Disclaimer: Trading in financial instruments carries various risks, and you can lose more than your capital. This article may contain general advice. You should always seek professional advice when deciding if a product is right for you.
What is a contract for difference?
A contract for difference (CFD) is a particular form of contract between you (payer) and your broker (seller) based on the price of a particular asset. When the contract is signed, this price is called the “entry price”, whereas at the end of the contract, it’s called the “exit price”.
See also: A guide to CFD trading in New Zealand
If the exit price of a particular asset is higher than the entry price, the seller has to pay the difference to the buyer: This is called the ‘long position’.
If the exit price is lower, the buyer has to pay the difference to the seller: This is called the ‘short position’. That’s why it’s called a ‘contract for difference’. It’s based on the prices and the buyer does not have any right over the asset.
Examples of assets can be shares indexes, shares and commodities such as gold or oil.
CFDs are normally purchased on a margin basis: Every financial derivative has its own percentage. The margin can be identified as a deposit for the purchase of a particular asset. If you buy 100 shares at $5 each and the margin is 5%, you will pay $5 x 100 x 5% which equals $25. There’s also the opportunity to take advantage of leverage. If you use a leverage of 100:1, your investment would be $5 x 100 x100 x 5% = $2,500.
Taking the long position
The long position means the trader expects the value of the security or asset in question to increase.
For example, stock XYZ trades at $5 and an increase is expected. If the investment is $5,000 and the initial margin is 5%, that means you can purchase 25,000 shares (calculated as follows: 5,000/5 = 1,000 shares divided per 5% = 25,000). Let’s assume that in two weeks the stock increases to $5.10 at the time of sale: The 5% is covered and the stock has appreciated. The profit is equal to the differential between the entry and exit price: ($6,375 – $5,000) = $1,375.
Please keep in mind that this is gross profit and that you have to subtract the cost of the trade being open for two weeks and also the trading commissions due. At the end of this calculation, you get the net profit from the long position.
The short position when prices fall
When the short position is discussed, the trader expects the value of the security, index, commodity or currency in question to decrease. An example is if the XYZ stock trades at $5 and a decrease is expected.
If the investment is $5,000 of funding and the margin is initially 5%, to gain a profit you need to sell the shares and then re-buy later on. You will sell 25,000 shares.
Let’s assume that the stock decreases to $4.75 in a couple of weeks, the 5% is covered and the stock has depreciated. This time you get $6,250 of profit. As mentioned in the previous case, this is gross profit.
This time, you need to add the amount of interest received for the two weeks when the position is open. The net profit is calculated as follows: Gross profit plus interests, minus the trading commission.
What’s the difference?
The difference between the long and short positions lies essentially in the interest rate that has to be subtracted from the gross profit in the case of the long position and added in the case of the short position.
Here you can see an example of how the long and short positions work:
|Long Option||Short Option|
|Fee CFD Position (open)||$150||$150|
|Fee CFD Position (closed)||$160||$140|
|Profit – gross||$10,000||$10,000|
|Interest subtracted (long)||$257||–|
|Interest added (short)||–||$235|
|Profit – net||$9,433||$9,945|
In this particular case, you could make a higher profit from the short position because of the ‘interest’ factor.
Let’s assume that in both cases you get a loss. In the long position, you have to add the interest, while in the short position you need to subtract the interest. In such cases, going long minimises the loss, whereas going short increases the loss.
Using leverage could also boost your profits as much as your losses: It would be better to limit this financial tool if you are a newbie.
As always, it is essential to think about the risks involved
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