If you’re thinking about getting into trading, or you’ve tried it but you’re still a beginner. Chances are you have come across the term ‘Contract For Difference’ and couldn’t help but wonder how to trade CFDs.
In general terms, a Contract for Difference, or a CFD, is a contractual agreement between a buyer and seller. The buyer commits to pay the seller the difference between the future value of an asset and its value at the moment the contract was made.
The profit made with a CFD comes when a trader anticipates a price change correctly. If the trader sees the asset’s price increase, they will offer their holding for sale and make a profit. On the other hand, if they think that an asset’s value will decrease they can place an ‘opening sell position’. To close the position, the trader must purchase an offsetting amount in a closing trade.
Having Stocks vs CFDs
At this moment you may be asking yourself. “How is a CFD any different from buying a stock”
A CFD is a contractual agreement with a specific timeframe. Whereas purchasing a stock gives investors part-ownership of a company. Stock ownership lasts for as long as you choose until you decide to sell it.
In simple terms, a CFD references the value of something, whereas buying a stock means you own something.
As with everything in life, trading CFDs has pros and cons. After looking at your goals, your abilities, and the current state of the market, you should be able to tell if you are ready to start trading CFDs. .
- You can trade both long and short positions with CFDs – betting for or against an asset’s value. Buying stocks only allows you to profit from growth unless you sell the stock short which carries its own risks.
- Instant order executions – You can open and close positions on the spot. Stocks take a few days to settle and you won’t have immediate access to the buying power of your funds unless you have a margin account.
- More leverage – There are stocks that won’t give you much profit unless you buy them in large volumes. Trading with CFDs allows you to control a larger position with less capital.
- Lower commissions – In many cases, the commission on CFDs may be lower than a similar trade through directly buying a stock. Portfolio diversification – Having a diversified portfolio is much easier with CFDs thanks to the availability of different financial instruments. From forex and stocks to crypto, energies, and other commodities like gold.
- World-wide access – Traders who trade with CFDs have the ability to trade worldwide markets from one account.
- Leverage can be a double-edged sword – Sure you can gain a lot from a smaller amount of capital, but you can also lose more than what you started out with. This magnification of profits and losses can be assessed through a thorough risk analysis.
- Traders pay the spread – for traders paying the spread on entries and exits reduces the possibility to benefit from small moves in the price. That means that in order to make a profit on a CFD you need a price movement that more than offsets the spread.
- Industry Regulation – Although there are some extremely reliable CFD dealers, decentralization in the industry makes it a necessity to examine the broker before doing business with them.
Usually, trading CFDs requires an upfront investment of time to understand their characteristics and risks. As with any investment, there is a risk of loss especially if you don’t really understand the product you are trading.
How to Trade CFDs
In simple terms, what you need to start trading CFDs is an account with a reliable broker and an initial trading plan. However, trading CFDs isn’t a one-step process.
After deciding on a broker and which assets to trade, you should continue to develop and refine your trading plan. This will help you set boundaries and over time should make it easier to limit your losses and maximize your gains.
Choosing a Broker/Asset
Choosing a broker and which assets to trade are the most important decisions you have to make, these are also the first decisions. Making sure you pick correctly will be important later on.
When picking an asset you have to make sure you actually understand how the market works. Learn to identify industry news that can affect your trades. You have to feel comfortable with making the analysis as well as have the ability to stay on top of any political or social events that may move the markets.
You also have to decide the level of risk you are willing to take on. Despite recent growth in the sector; crypto is still a volatile asset class. If you decide to trade it with CFDs you have to educate yourself well beforehand. Make sure your trades are within your comfort level and that you understand the risks you are taking.
Now, when you’re picking a broker you want to make sure that they’re reliable. Working with a trustworthy broker that has competitive prices and a trading platform that you can master will make or break your trading plan. So before deciding to go into business with one, contact them and test their customer service.
Open a few demo accounts to get the feel of what it’s like to trade with them. Most importantly, read online reviews to see what customers have said about them, and ask them if they offer any additional guidance or educational resources, or market tools.
Although not every company in the CFD industry is regulated, making sure you have a broker that is backed by a good license and regulatory regime will help you gain a better sense of security.
Also, make sure you learn as much as possible about them; their fees, commissions, and any possible delays that you may encounter. Remember that you will be doing business with this company, so you want to know absolutely everything about them.
Developing a CFD trading plan
Executing a trade is simple when compared to the other steps. Choosing the size of the position, setting up a stop loss, and placing a limit are simple actions. Yet, if you don’t have a well-thought-out trading plan, your trades might become stressful and you may end up losing. So in order to avoid this make sure you have a concrete plan with the basics.
What is a basic trading plan made of?
Developing a trading plan is easy, profiting from one is more diffiuclt. A detailed plan will have many steps and will change according to each trader’s goals. But they all share some things in common. All trading plans will have an entry strategy that tells the trader when it’s time to buy – or sell if they’re going short.
An exit strategy, that signals when it’s time to take the profit (or loss) and finally a risk analysis. You never want to trade more than you can afford to lose. Besides pursuing your goals you should always make sure you have the ability to accept the risk you are taking on..
Once you have your plan mapped out you can start executing your trades.
Remember: Deciding on the size of the position depends on the asset, the size is measured by points. So make sure you know what one point means for the asset you wish to trade since it can represent different units. The price of a unit varies according to the currency quoted.
Executing your trading plan
So you have your plan, you chose a great broker and you enjoy doing business with them. Your next step is to execute your trades according to your plan and keep a journal of what you have done, what works, and what doesn’t, and learn from your mistakes.
It’s important to remember to document your journey. Not only will you be able to look back and make some necessary modifications to your trading plan but it’ll keep you in check so you control your emotions. Too many times we fall into the herd mentality. Get a severe case of FOMO and we end up making the wrong choices.
It’s important to keep a cool head when executing your trade. Humans are emotional beings, and we tend to let those emotions control us. The best way to do this is to stick to your trading plan. And even though no one likes losing money, make sure you never invest more than you can afford to lose.
Finally, In the tech world countless glitches can occur, so if this ever happens to you, make sure you take screenshots and document the error. So when you go to customer support, you will have proof to back up your claims and the process of sorting the error out will go by faster.
CFD Trading Example
Since a CFD trade has a little more steps and complexity than a regular stock trade we included a small example.
Disclaimer: The following example is not real and should NOT be taken as financial advice.
TSLA has a selling price of $615.59 and a buy price of $615.60.
TSLA’s next earnings announcement is fast approaching, and you expect it to be good news. You think the company’s share price will go up, so you buy 2000 share CFDs at $615.60.
Since your trade is leveraged. You only need to cover the margin, which is calculated by multiplying your exposure with the margin factor for the market you are trading.
So if TSLA has a margin factor of 5%, then your margin would be 5% of the total exposure of your trade (2000 shares CFDs x $615.60 = $1,231,200 x 0.05), which is $61,560.
If you read the market correctly:
When TSLA announces its results. It’s clear the company has had a successful quarter – and as you predicted, its share price climbs. You decide to close your position when it reaches $690.60. With a buy price of $690.61 and a selling price of $690.60.
You reverse your trade to close a position, so you sell your 2000 CFDs at a price of $690.60.
To calculate your profit, you multiply the difference between the closing price and the opening price of your position by its size.
$690.60 – $615.60 = $75, which you multiply by 2000 CFDs to get a profit of $150,000.
Just remember that you’ll also need to pay a commission fee and any overnight funding charges. Please refer to your tax adviser for tax matters.
If you read the situation incorrectly, You would do the same operation but your losses would be multiplied likewise. So let’s say that instead of raising $75 above the original buy price, TSLA shares drop to $550.
Your losses would have been -150,000. In this case, you would have been better off setting a stop loss. that corresponds to your trading plan.
Generally speaking, there are some people who prefer to set their win/loss ratio of 3:1. This means for every $ they are willing to lose, they look to gain 3.
So if this were applied to the above example. The limit would have been set at $75 above the original buy share price (615,60 + 75). And the stop loss would have been set up at $25 below the original share price (615,60 – 25)
Trading CFDs has many benefits. Yet if you’re not careful enough, the risks may outweigh the rewards. If you decide to trade CFDs remember to get to know your broker. Reliability is everything, so test their customer support and get to know their platforms. Opening a demo account can give you the experience of working with them.
Get a feel for the markets and choose a niche. You could burn yourself out trying to keep up with too many industries, especially if you are just starting out. Once you become an expert in a niche, understand how the markets work you will begin to develop a trading plan.
Your trading plan will be your biggest ally. It is the base that will help you keep aligned with your goals and a way to control your emotions. Once you have your trading plan, make a habit of trying new things on a Demo account.
When you actually start trading, keep a journal of your journey. Write down where you make errors, and learn how to fix them. Trading, in general, is a learning process, CFD trading has its own risks. Try trading in a low-risk environment such as a demo account with a low value before you give it a full shot.
On a side note, please remember to account for any fees and commissions. Talk to a tax rep to find out how much you might have to set aside for paying taxes.
While it’s an entirely different subject, in some jurisdictions tax on capital gains will be part of your trading strategy. So make sure you double-check your local laws in relation to trading and taxation.