What Is A CFD?
A CFD is a contract between two parties. They agree to pay the difference between the opening price and closing price of a particular market or asset. It is therefore a way to speculate on price movement, without owning the actual asset.
The performance of the CFD reflects the underlying asset. Profit and loss are established when that underlying asset value shifts in relation to the position of the opening price.
When trading CFDs with a broker, you do not own the asset being traded. You are speculating on the price movement, up or down.
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Lets use an example. Say you select a stock with an ask price of $25 and you open a CFD to the value of 100 shares.
If buying shares the traditional way, the cost would be $2,500. There might also be commission or trading costs.
However, a CFD broker will often require just a 5% margin. This will allow you to enter the same trade but with only $125. (Actual levels of leverage or margin will vary). This makes it an attractive hunting ground for the intraday trader. The risk and reward ratio is increased, making short term trades more viable.
When you enter your CFD, the position will show a loss equal to the size of the spread. This means if the spread from your broker is 5 cents, you’ll need the stock to appreciate by at least 5 cents to break even.
CFD vs Stock
Using the above example: Let’s say the price of the underlying stock continues to increase and reaches a bid price of $26.00
If you owned the stock, your holding is now worth $2600. A nice profit – ignoring commission or trading costs the trader realised $100.
However, with the underlying stock at $26.00, the CFD would show the same $100 profit – but it required way less to open, just $125. So in terms of percentage, the CFD returned much greater profits. Had the market moved the other way, losses relative to our investment would have been larger too – both risk and reward are increased.
There are of course other benefits to owning an asset rather than speculating on the price. We also ignored commissions and spreads for clarity. But the above does illustrate the relative differences in the two methods of investing.
As you are day trading you probably won’t hold any CFD positions overnight. Instead, you’ll likely place a high number of CFD trader in a single day. To maximise your returns you’ll want to concentrate on liquid volatile markets. CFD trader with oil, bitcoin, and forex are all popular options, for example.
You may have already gleaned a couple of advantages above from CFDs, but let’s break them down and add a few more.
Leverage – CFD leverage is much higher than traditional trading. You can get margin requirements as little as 2%. The rate usually depends on the underlying asset. Shares or volatile cryptocurrencies, for example, can reach up to 20%. Whilst low margin rates will allow you to take big positions with less capital, losses will also hit you harder.
Accessibility – The best CFD brokers will allow you to trade in all of the major markets. With so many markets that means CFD trader hours effectively run 24 hours a day. You’ll just need to check your brokers trading hours first.
Cost –CFD systems incur minimal costs. You will find many brokers charge little or zero fees to enter and exit trades. Instead, they make their money when you have to pay the spread. The size of the spread will depend on the volatility of the underlying asset. Note it is usually a fixed spread.
Less shorting rules – Some markets enforce rules that prevent you shorting at certain times. They can demand greater margin requirements for shorting as opposed to being long. The CFD market, however, generally doesn’t have such rules, as you’re not actually owning the underlying asset. This means no borrowing or shorting costs.
Less day trading requirements – Some markets require significant capital to start trading. This limits you to how many trades you can make, and in turn how much profit. An online CFD trader, however, can set up an account with as little as $1,000 to $5,000.
Diversity – Whatever peaks your interest, you’ll probably find a CFD vehicle. You can start CFD FX trading, as well as utilising treasury, commodities, cryptocurrencies, and index CFD
How To Start Trading CFDs
One of the selling points of trading with CFDs is how straightforward it is to get going. You’ll need to follow just five simple steps.
1. Choose A Market
There are thousands of individual markets to choose from, including currencies, commodities, plus interest rates and bonds. Try and opt for a market you have a good understanding of. This will help you react to market developments. Most online platforms and apps have a search function that makes this process quick and hassle-free.
2. Buy Or Sell
If you buy you go long. If you sell you go short. Bring up the trading ticket on your platform and you will be able to see the current price. The first price will be the bid (sell price). The second price will be the offer (buy price).
The price of your CFD is based on the price of the underlying instrument. If you have a reason to believe the market will increase, you should buy. If you believe it will decline you should sell.
3. Trade Size
You now need to select the size of CFD trader you want to trade. With a CFD, you control the size of your investment. So although the price of the underlying asset will vary, you decide how much to invest. Brokers will however, have minimum margin requirements – or more simply, a minimum amount that is required in order for the trade to be opened. This will vary asset by asset. It will always be made clear however, as will the total value (or your exposure) of the trade.
Volatile assets such as cryptocurrency normally have higher margin requirements. So a position with exposure to $2000 worth of Bitcoin, might need margin of $1000 for example. A well traded stock however, may only need 5% margin. So a $2000 position on Facebook, may only require $100 of account funds.
4. Add Stops & Limits
This will help you secure profits and limit any losses. Most CFD strategies for beginners and experienced traders will employ the use of stop losses and/or limit orders. They tie in with your risk management strategy. Once you have defined your risk tolerance you can place a stop loss to automatically close a trade once the market hits a pre-determined level. This will help you minimise losses and keep your accounts in the black – leaving you to fight another day on subsequent trades.
A limit order will instruct your platform to close a trade at a price that is better than the current market level. If you opt for a trading bot they will use pre-programmed instructions like these to enter and exit trades in line with your trading plan. These are perfect for closing trades near resistance levels, without having to constantly monitor all positions.
5. Monitor & Close
Once you’ve placed your trade and stop or loss limits, your profits will shift along with the market price. You can view the market price in real time and you can add or close new trades. This can be done on most online platforms or through apps.
If your stop loss or limit order hasn’t been activated you can close it yourself. Simply select ‘close position’ from the positions window. You will be able to see your profit or loss almost instantly in your account balance.
Choosing the right market is one hurdle, but without an effective strategy, your profits will be few and far between. You need to find a strategy that compliments your trading style. That means it plays to your strengths, such as technical analysis. It also means it needs to fit in with your risk tolerance and financial situation.
Below two popular and successful CFD trading strategies and tips have been outlined.
1- Breakout Strategy
This simply requires you identifying a key price level for a given security. When the price hits your key level, you buy or sell, dependent on the trend. The main thing to remember with breakout trading is to avoid any trades when the market isn’t providing clear signals.
If you can’t quite tell which direction the overall trend is moving in then give it a miss. This is where detailed technical analysis can help. Use charts to identify patterns that will give you the best chance of telling you where the trend is heading.
2- Contrarian Strategy
This is all about timing. Your plan rests on the knowledge that trends don’t last forever. If a stock’s price has been on the decline then you identify a point where you believe it’s near the end of the trend. Then you enter a buy position in anticipation of the trend turning in the other direction.
You can follow exactly the same procedure if the price is rising. You can short a stock that has been increasing in price when you think a sharp change is imminent. Both Wave Theory and a range of analytical tools will help you ascertain when those shifts are going to take plac
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Day trading CFDs can be comparatively less risky than other instruments. Having said that, it will still be challenging to craft and implement a consistently profitable strategy. If you want to be a successful CFD trader you will need to utilise the educational resources above and follow the tips mentioned. As successful trader Alex Hahn pointed out, If you master your thinking and your emotions, nothing can stop you.’ So, the ball is in your half of the court now, go and turn it into gold.
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