If you’ve been investing for awhile and are looking at some alternative ways to put your money to work, you might want to consider CFD trading. It has become a popular way of trading on equity derivatives in the last few years. There are a number of benefits related to this form of investing.
If you are a beginner, you need to know some useful information on the derivatives product CFDs. Here we will see what it stands for, give an example and show some rules to follow when trading.
Contract for Differences (CFD)
CFD stands for contract for difference. It is an equity derivative trade and is an agreement between the trader and the broker. The agreement is made to exchange any differences in value of an underlying asset between the time when the contract is opened and when the contract is closed without ever owning the underlying asset.
CFDs complement traditional investing methods such as trading in individual stocks. Although requiring some study before proceeding, CFD trading is easy to understand and trades well in the different types of underlying markets.
CFDs are similar to the futures and options branch of trading. The closest cousin of trading CFD online is spread betting.
Example of CFD Trading
CFDs are traded in lots of 100 shares. So suppose you are buying a CFD on a stock which has a price of $10 and it rises to $10.50 in the direction you expected. Using a CFD for that stock you would have made you a profit of $50.
For example, per Investopedia:
If a stock has an ask price of $25.26 and 100 shares are bought at this price, the cost of the transaction is $2,526. With a traditional broker, using a 50% margin, the trade would require at least a $1,263 cash outlay from the trader. With a CFD broker, often only a 5% margin is required, so this trade can be entered for a cash outlay of only $126.30.
If the underlying stock were to continue to appreciate and the stock reached a bid price of $25.76, the owned stock can be sold for a $50 gain or $50/$1263=3.95% profit. At the point the underlying stock is at $25.76, the CFD bid price may only be $25.74. Since the trader must exit the CFD trade at the bid price, and the spread in the CFD is likely larger than it is in the actual stock market, a few cents in profit are likely to be given up. Therefore, the CFD gain is an estimated $48 or $48/$126.30=38% return on investment. The CFD may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 is a real profit from the CFD, where as the $50 profit from owning the stock does not account for commissions or other fees. In this case, it is likely the CFD put more money in the trader’s pocket.
You can also sell CFDs short in the case of falling markets which allows you to benefit when the market is going down. You don’t need to own the underlying asset as you are simply looking to profit from the fluctuations in the prices.
Rules for CFD Trading
As we all know, there is no money-making venture that is easy. All businesses need proper management skills and techniques to grow and be successful. The same holds true with CFD trading. If you aspire to a good CFD trader here are 5 rules that you should always abide with to get you closer to your goal:
1. Develop your trading and management techniques
In order to succeed in CFD online, you need to come prepared. Do your homework and learn at the very least the basics of the trade. As with any other business, you cannot simply come in and start. Try to research on techniques and learn tips on how online trading works.
Asking another broker initially is part of learning, so try to be open about learning from another with more experience than you. As a new trader, acknowledge your limitations and absorb as many lessons and information as you can. Give as much passion to learning as you would to trading.
2. Start trading small
One of the most devastating things that could happen to a new trader is losing all his account after a few trades. This can make you lose your motivation and focus.
In order to avoid this keep in mind to start small with your CFD trading demo account. Invest only a relatively small amount of money in any single trade. Once you gain more experience and learn more about the workings of CFD trading, then you can start trading higher amounts.
3. Focus on few markets only
If you are going to start trading on multiple markets then you will find it almost impossible to focus. Then, if you start neglecting markets, losses will inevitably follows. Successful trading needs proper planning and analysis. You wouldn’t be able to properly plan and carefully analyze if you are juggling numerous markets.
At the end of the day, you should never bite more than you can chew.
4. Learn from your mistakes
Trading is a continuous learning process. Mistakes are inevitable especially when you are new and inexperienced. The best thing for you to do is to always learn from your mistakes.
Find time to reflect on every trade and analyze what went wrong and what you should have done. By doing this routinely, your mistakes can be converted to something positive.
5. Reduce your earning expectations with CFD trading
Every business needs time to grow before it starts generating profit. The same goes with CFD trading. You cannot expect to immediately earn a sizable amount of money in your first few trading ventures.
Keep in mind that it takes time before you see your profits and gains. Being a successful trader does not happen overnight. You need to be seasoned with time and experience. Be patient and start with a realistic mindset so that you will not lose your motivation and passion.
The items above are just some of the things that you need to observe to ensure that your losses will be minimal. If you are open to suggestions and keen on learning from your mistakes, you are already half-way to your journey of being a good trader.
Questions: Have you ever heard of or done CFD trading? What other benefits and risks of CFD trading do you see?