Contracts for difference provide a unique form of trading. It is mostly used by advanced traders who generally understand the ins and outs of trading. Of course, there are probably some rookies who like risks who may be interested in trading CFDs as well. Luckily, there’s enough room for both newbies and veterans. Let’s take a closer look at CFDs.
What Are CFDs
Contracts for difference (CFD) are agreements made between a trader (buyer) and a broker (seller). The contract is based on speculations on price movements within the market. The agreement stipulates that at the end of the contract, the parties exchange the differences between the initial price of the asset when the position was opened and the asset’s value when the position is closed.
When the difference is a profit, the broker pays the trader but when it is a loss, the trader has to pay the broker.
There are essential steps involved when it comes to CFD trading. Let’s take a closer look at them.
Understanding CFD Trading
- Choose An Instrument
CFDs can be traded on several markets. Traders can invest in CFD shares, indices, bonds, commodities, and many more. This long list creates many options for investors to choose from. However, for a new trader, it can be confusing. That is why a lot of time should be invested in studying and research. When a trader has a clear understanding, they can make a choice that is best suited to their needs.
- Choosing A Trading Position
After deciding on an instrument is important to choose a trading position. This essentially means to decide whether to go long i.e. buy CFDs or go short i.e. to sell.
Investors need to know the prices of the underlying assets before choosing a trading position. Have a budget before investing so that you know what to spend.
- Choose The Size Of Your Trade
CFD trading allows traders to select the number of CFDs to trade. This will therefore be influenced by the preferences and goals of the investor.
The value of CFD will vary based on the type of instrument used. For example, in the case of equities, a single CFD is equivalent to a single share. This value will not be the same when trading commodities or bonds.
CFDs work well because of leverage. Investors only need a small percentage of the full value of the underlying asset to trade. This amount is referred to as margin. The amount required for the margin will be highly dependent on the asset’s value. The higher its value, the higher the asset’s value, the higher the chance of the margin being too high.
- Consider Risk Management Strategies
Every trader must learn to manage risks. Consider some management strategies and learn how to implement them. This is why stop orders and limits are so essential.
A simple yet efficient step a trader can take is placing a stop order. This will automatically close an open position when triggered. It is usually set when prices are moving against the trader’s speculation. Stops will limit the losses made so that they do not go beyond a certain level.
A limit is a way for traders to be disciplined in their trades. It essentially helps them stop while they’re ahead. It is usually triggered at a certain price level. Essentially if the prices reach a certain high or low (depending on whether it is a long or a short call, the limit is activated to close the trade. This is a great way to lock in profits. Waiting could ultimately lead to losses in the long run.
- Monitoring Trades
CFDs are short-term trades, meaning they have to be observed keenly. Traders can monitor price movements in real-time. However, if stops and limits are set, there usually isn’t a very serious need to observe so closely.
Monitoring the fluctuations in the market can be as simple as using a phone or computer.
- Close The Trade
If the trader is ready to close the trade, they may do so by simply selecting the ‘close position’. This closes the open trading position and profits or losses will be released.
CFDs are a unique form of trading. It has many useful benefits including how traders can use it as leverage.