Calculus of potential profit and loss with any transaction should be central to the research process, and ultimately a trader decisions whether or not to get involved. With certain trades, for instance, it may seem like an upwards movement is definite, but how heavy does that upwards market movement need to be in order to make that transaction worthwhile? Fortunately, when trading CFDs, the profit/loss mechanism is built in to the nature of the instrument, making it easier than most to calculate the value of the settlement of the position at a given rate.
The calculations for determining the profitability of a particular trade are relatively easy, provided you understand how the mechanism of a contract for difference works. A contract for difference, by definition, is an agreement to settle on the difference between the price of the underlying instrument today and its price at some future point when the transaction is settled. If prices go up, the buyer is in profit, and if prices go down, the seller is in profit. As a trader, it is possible to be both buyer and seller, depending on your outlook for the future of a particular asset class.
The profit calculation is online slightly further complicated by the interplay of margin and leverage. As naturally leveraged products, CFDs are geared up to a higher degree than the trader need afford to cover initially. Often this can run at as low a 3% margin requirements, which essentially means that the trader need only cover 3% of the transaction size from his trading capital, with the remainder financed by the broker in the short term. This allows much more significant gains to be realised from the same transaction.
Thus, the essential information you need to know in order to calculate profit from a CFD transaction is as follows:Starting price: the price at which you entered the position, either buying or selling the contract for difference.
Exposure: the extent to which you are personally (i.e. excluding the leveraged portion) exposed to the position.
NMR: notional margin requirement, expressed as a percentage
Variable end price: the variable price at which you want to calculate your profit.
The calculation for working out the gross profit on any CFD long position is:
(Variable end price - Start price)/100 x (Exposure/NMR) = Profit
This nifty little formula works out the value of your profit portion from a leveraged CFD transaction excluding any brokerage fees that may apply. In order to calculate a rate of return, the profit figure must then be calculated as a percentage of the original exposure figure, in order to correctly calculate returns.
Calculating Loss, and Short Positions
Calculating loss from a particular CFD transaction effectively works by the same process as calculating profit, except that the output is negative rather than positive. In this instance, the equation becomes switched slightly such that the Variable end price is deducted from the Starting price, because the market is moving down rather than up. When trading with CFDs, calculating potential loss in this way is a worthwhile endeavour, because the outcome can often provide a sobering reality as to the dangers of a particular transaction.
Similarly, in calculating short positions the equations are simply reversed to calculate profit (as if it were a loss with long positions) and losses accordingly.
Knowing how to calculate profit and loss for both long and short positions isn't just a point of interest - it is actually a very significant and useful tool that successful traders need to grasp as quickly as possible if they are to succeed online. These quick, simple calculations can help identify in an instant whether your expectations are unrealistic or whether the risks of a particular transaction are too high, enabling you to make dynamic, on the spot decisions in full comprehension of the market situation.