Active Management using CFDs: long trade example
Underlying Equity CFDs can be not only single shares but also equity indexes. Index CFDs are very useful because the investor hasn’t to trade a specific view on individual shares but, investing on an equity index, he can generate profits (or losses) on the back of the move of a series of individual shares linked together by the index.
As for shares CFDs you can go long or short, buying or selling index CFDs in many of the major equity world indexes: Ftse100, Dow Jones, Nasdaq100, S&P500, Nikkey and many others.
Index CFD providers normally quote a price (bid and offer) based around the current index price (index CFD price and underlying equity index price are connected).
Generally for the Ftse100 each point is equal to £1 and so, if Ftse100 index is trading around 1000 level, the value for 1 Ftse100 CFD would be around £1.
As a result of that, CFDs providers for Ftse100 are offering 5% initial margin (investing 5% for Ftse100 CFD, you are exposed to 25% Ftse100 price movement).
Let’s assume Ftse100 CFD is currently trading at 4998-5000 and you are forecasting a potential 10% rally by 5 weeks horizon.
Unfortunately you invested 95% of your equity portfolio in different shares than those correlated to Ftse100 index and so you will not benefit from Ftse100 rally.
If you are managing your equity portfolio with a passive approach, you can try to invest 5% of liquidity ih the main share for Ftse100 index (share with biggest weight on the index) but this implies that you are able to know the updated Index weigh.
In anycase if you are right and Ftse100 goes up by 10%, you will benefit just for the share portfolio’s weight profit or: 10% * 5% = 0,5%.
On the contrary, if you are managing your equity portfolio with an active approach, you can invest 5% of the liquidity buying Ftse100 CFD and so being exposed to 25% Ftse100 price movements.
Today 5% portfolio liquidity represents £1.250 and you decide to buy 5 Ftse100 CFD at 5000 (remind that 5000 represents the ‘offer’ price at which Ftse100 CFD provider sells it).
Each Ftse100 CFD represents a value of £1 and so 5 CFD at a price of 5000 represent a total purchase value for your portfolio of: £5*5000= £25.000.
If £1.250 represents 5% of your equity portfolio, £25.000 Ftse100 CFD purchased value represents the total amount of your equity portfolio.
Using Ftse100 CFD you are able to double the equity amount invested, using just 5% of the liquidity because of the initial margin required of 5%: £25.000*5% = £1.250.
If after 5 weeks you are right and Ftse100 index is 10% higher, on the back of Ftse100 index and Ftse100 CFD correlation, also CFD price will be 10% higher.
Ftse100 CFD is quoting at 5048 – 5050 today.
To close out Ftse100 CFD position you have to sell 5 Ftse100 CFDs; you have to trade the bid price (the price at which CFDs provider buys CFDs) and so you sell 5000 Ftse100 CFD at 5048 for a total value of £25.240.
CFD profit equals the difference between the total value of CFD sale amount and that of CFD purchase amout or: £25.240-£25.00 = £240.
£240 represents 2,4% equity portfolio increase.
Using Ftse100 CFD, on the back of investing just 5% of liquidity, you generated a portfolio profit by 2,5% or a return on invested liquidity of 50%.
P.S. Investing on margins can cause also huge losses: in the previous example, due to an unfavourable Ftse100 drop by 10%, you could generate losses by 2,5% instead a profit by same % amount in 5 weeks time.