Your Ultimate Guide To CFD Trading

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Your Ultimate Guide To CFD Trading

Contracts for Difference, better known as CFDs, are a trading product which is ideal for speculating on financial markets. Best-suited for experienced traders, understanding what CFDs are and how they work can be somewhat confusing. This detailed guide will explain all you need to know about them, and if they are the right trading product for you.

An Overview of CFD Trading

CFD trades allow traders to speculate on asset markets without needing to physically purchase or sell the underlying asset. Based on a trader’s gamble, he or she can profit from the asset’s future value, both if it increases, but also if it decreases. This difference in value is better known as a movement. As a derivative product, the CFD’s value is not directly linked to its underlying asset but comes from the value put upon it by traders and brokers.

By trading CFDs, you can speculate on a variety of assets, including shares, indices, forex and commodities. Bitcoin CFDs are also becoming extremely popular, as are contracts linked to other cryptocurrencies. Although CFDs are a popular trading product, they are unavailable in a variety of countries, most notably the United States. As a result, Europe marks the most popular market for these products.

How Does CFD Trading Work?

The best way to explain how CFD trading works is through an example. Take Asset A, which has a purchase price of €40 per unit, and you intend to purchase 50 units. The cost of your purchase will be €2,000 for the asset, and another amount for fees and commissions. Normally such a trade would require you to put up €1,000 in cash with a broker who gives you a 50% margin. However, a CFD broker would, for example, only ask for 5%, or €100.

When you trade CFDs you need to pay the spread, which is the difference in price between buying and selling. You purchase the contract with the buying price, and exit using the selling price. The smaller the spread, the smaller the movement needs to be in your favour for you to make a profit. 

Back to your asset, let’s consider that after your purchase, the asset’s value increases by €0.50, to €40.50 per unit. In a traditional trade, you would be able to sell it and make a 2.5% profit, excluding fees. However, depending on the exchange, the CFD price might not reach the same value. For our example, let us assume that the CFD’s value only rose by €0.40. Your profit would, therefore, total €20, but this translates to a 20% profit due to the more favourable margin. Furthermore, when trading CFDs, you won’t have additional fees or commissions to deduct from your profits.

Therefore, even though the spread may be higher with a CFD broker than a traditional market broker, your profits are generally greater than if you buy the underlying asset. In a reverse scenario, where your speculation turns out to be incorrect, you risk losing more than you would have in a traditional trade.

CFD Trading: Useful Terms & Definitions

In order to fully comprehend CFD trading, you must get acquainted with its jargon. Any industry has its own little language, even cryptocurrency, and understanding these common terms will help you understand the rest of this guide better.

Contract Value

The full purchasing cost of the contract’s underlying asset. For example, a contract for 500 units of Asset A would have a contract value of 500 x Asset’s A single unit price.

Demo Account

A demo account is a fictitious trading account which you can use to practice trading CFDs without any risk of losing your money. It is offered by some of the best CFD brokers, including eToro and Plus500.

Leverage Margin

Leverage margin is an example of margin trading, which is simply the process by which an investor borrows an amount of capital from a broker in order to open a much larger position than he or she could otherwise open. The bigger the leverage, the higher the multiple that can be borrowed.

Limit Orders

Limits are trading tools which allow automatic trades based on pre-set buying and selling prices. These tools allow traders to enter or exit the market at a more favourable return than the current market value, without having to constantly watch the price.

Loss

A loss is experienced by a trader when a contract’s value is moving in the opposite direction, thus going against the speculator’s gamble.

Rollover

Rolling over your investment means extending your position beyond an expiry period, oftentimes the end of the day. Rollovers come with specific conditions and can incur additional fees.

Slippage

When markets are experiencing high volatility, it may be unable to execute a buy or sell exactly as per your instruction due to the erratic price movements. Instead, the price might vary slightly.

Spread

The difference between the bid (buy) price and the offer (sell) price for a specific asset.

Stop Loss Order

This is a risk management instrument which protects traders and brokers from massive losses. A stop loss order remains activated until either the order is de-activated or the position is closed.

Underlying Market

The futures or exchange price upon which your CFD quote is based.

Advantages of CFD Trading

There are several advantages to trading CFDs, not least that you don’t need to go through the hassle of safely storing your asset. If you are trading forex, for example, this is not really a concern, but if you are purchasing barrels of oil or gold, then the logistics headaches begin. Here are a few more advantages to CFD trading.

Short a Stock with Ease

While certain markets may forbid shorting, or require the trader to comply with certain conditions, trading CFDs allows shorting at any time and at no additional cost. Since the trader does not own the underlying asset, he or she is able to short Bitcoin CFDs or any other applicable asset.

No Need for a Substantial Trading Capital

Due to the possibility of higher leverage than other products, trading CFDs can be carried out with very low margins, as low as just 3%. Lower margins equate to less trading capital, with the potential for greater returns. However, leverage can also magnify losses.

Enjoy Gaining Access to Many Markets

The primary CFD trading platforms allow you to speculate across different markets and assets. With just one account, you can trade a variety of assets, including indices, cryptocurrency, and forex.

Fact: CFD Trading is a Calculated Risk

Although trading CFDs could provide you with positive returns, due to the high risk involved you should never invest the majority of your capital in such products. It is important that before you start trading CFDs you understand the risks involved.

Counterparty Risk

The counterparty is the provider of the contract which is being traded. Should the counterparty fail to meet its financial obligations with you or any other client it conducts business with, then the value of the contract may diminish or disappear.

You Can Lose Everything, and Then Some

CFD trading is a fast-moving investment product which experiences liquidity risks and margins which you, as a trader, need to maintain. If the value moves against you and you are unable to cover the difference, the provider will probably close your position, which means that you lose all your invested funds. Since you do not own the asset, it doesn’t matter if the asset’s value increases later.

Furthermore, due to leverage being used in CFD trading, your losses may go beyond the initial capital you have invested. This is why it is always recommended to set Stop Limits.

Margin Top Up

When a price movement is highly volatile, your broker may require you to urgently top up your invested capital in order to keep your position open. Not fulfilling this requirement in time will lead to the closure of your position and associated losses.

Price Discrepancies

The price charged by your CFD provider may be more expensive than the asset’s value when bought on an exchange.

Breaking Down the Cost of CFD Trading

While the fees associated with CFD trading are normally lower than most traditional trading products, they are still significant. It is important that you understand the exact costs of your broker prior to opening a position, in order to calculate the minimum price movement required for you to turn a profit. The following are the primary costs involved with CFD trading.

Commission

Commissions are charged whenever you open or close a position, and are normally a percentage of the value of your trade. Certain platforms charge a minimum commission which you will have to pay if the percentage does not exceed it.

Spread

Whenever you buy a CFD you need to cover the spread cost, which is calculated as the difference between the asking price and the bidding price. Low liquidity markets tend to have larger spreads which make it more difficult to get a return from a trade.

Holding Costs

Holding costs are comparable to loan interest rates. When you borrow an amount from your CFD broker in order to open a position, you are charged holding costs on this amount. These costs increase every day that your position is kept open until the debt is repaid.

Market Data Fees

Market data fees are monthly charges which traders pay in order to access price data, especially for international markets. This fee varies considerably between brokers, and can also be completely waived if you are a regular trader.

What’s the Realistic Seed Money Needed to Start Your CFD Trading Journey?

As mentioned earlier in this CFD trading guide, you should only invest part of your capital in this product due to the high risks involved. However, this budget would still need to be of a certain size in order for you to have a good opportunity to turn a profit. 

Basing yourself on the advice of industry experts, it would be ideal if you could begin with a seed capital of around €20,000. This value is based on the following assumptions and calculations:

  • Using a realistic commission of 0.1%, you will pay €20 every time you open or close a position (assuming you invest all your capital in just one CFD)
  • Taking 50 trades in a year, almost 1 a week, this works out to €2,000 (ignoring any potential movement)
  • This means that in order to break even you need to earn at least 5% on your trades
  • With a smaller capital, the required profit margin gets even higher

Whilst it is possible to invest in CFDs with a smaller seed fund, it becomes much riskier and puts additional stress on your decision-making.

Looking for a Reputable and Reliable CFD Broker

Using a reputable and reliable CFD broker can make all the difference in your trading experience and subsequent results. Choosing the right broker can be difficult, especially if you are new to the CFD game, but here are a few tips to help you choose the right one.

  • Choose brokers who are regulated. CFD trading is risky enough without needing to worry about a dodgy broker who scams you.
  • Have a look at support options. If you need to get in touch with your broker, the process should be easy. Some of the best brokers offer multiple options, including live chat.
  • Withdrawals should be almost as easy as deposits. While it is ok to have to wait a couple of days for withdrawals to be processed, you should not have to chase the broker for your money.
  • The platform and markets should suit your needs. You know what you wish from your broker, so use demo accounts until you find the right combination of markets and features.

Should You Opt for CFD Trading?

At this point in this CFD trading guide, you might be unsure whether this investment product is right for you. Answer the following questions and find out the answer now.

Are you a long-term investor?

CFD trades are fast and incur holding fees for every day that they are kept open. 

Do you lack sufficient knowledge in CFD Trading?

Although this guide should help you understand CFD trading it cannot provide the knowledge you need to successfully trade specific assets. Understanding the movements of these assets is essential to correct speculation.

…if you’ve answered ‘yes’ to these questions, then CFD Trading is not for you. 

On the other hand…

Do you want to hedge your portfolio?

This involves taking on the opposite side of your trades, lowering your portfolio’s volatility.

Do short stocks interest you?

Carrying out short selling is an alternative trading mechanism which allows you to turn a profit when the price of an asset drops.

Do you want to trade in a variety of markets?

CFDs allow you to trade with a mixture of markets, such as forex, stocks, and futures, using one single platform.

…if you’ve answered ‘yes’ to these questions, then CFD Trading might very well be for you.

Concluding Thoughts

While this guide has served to teach you all that you need to know about what CFD trading is, how it works, its benefits, and its risks, you still need to research the market or markets which you intend to invest in. Markets are affected by a variety of internal and external factors, and it is important that you are aware of what these factors may be.

In the case of Bitcoin CFDs, for example, external factors may include industry legislation or project announcements. The best way to stay informed of such information is to follow cryptocurrency news.

The advantages of CFD trading are considerable and are even more significant when you are trading tangible assets. Using a conservative budget you can trade on margin, exposing yourself to huge potential gains, or losses. While there is no sure strategy for success, informing yourself of the market, understanding asset charts, and using automated tools such as buy/sell limits should give you a higher probability of turning a profit, or, at the very least, limiting your losses.

Before you begin trading CFDs you should ensure that your investment strategy and capital allows it. There is no sense in investing in this product if you do not have sufficient starting capital, or if you do not have the time for short-term investments.

Once you have decided to trade CFDs, your next task is to settle on a reliable broker. Make use of demo accounts to try different platforms and test a few trades. Be sure to also check on the broker’s fees so as to calculate what minimum profits you should make on each trade. 

In conclusion, as long as you understand the risks and charges involved, CFD trading could contribute a significant return to your investment portfolio. As an experienced trader, CFD trading offers you an opportunity for higher profits based on your in-depth understanding of the market.

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