What is a CFD?
A Contract for Differences (CFD) is a financial contract between a buyer and a seller to trade on financial instruments based on price differences between the entry and closing prices. This instrument stipulates that the buyer must pay the seller the difference in settlement prices of underlying assets. If the closing trade price is higher than the opening price, the seller will pay the buyer the difference, the buyer’s profit. The opposite is also true. Suppose the current asset price is lower at the exit price than the value at the contract’s beginning. In that case, the seller will gain from the difference. This difference will be cash-settled through brokerage accounts.
A CFD provides traders with a prospect to leverage their trading by having to put up a small margin deposit to take a trading position. This allows traders to amplify the size of their potential returns without the need for much capital to begin trading. Additionally, traders can earn returns from price returns of an asset without taking physical delivery. Thus, the strategy offers traders flexibility and higher returns.
However, the higher returns come with increased risk. The CFD markets have fewer regulations compared to other exchanges to protect investors. Furthermore, leverage is a double-edged sword; it can amplify losses the same way it amplifies returns. For these reasons, CFDs are complex financial instruments and are not recommended for inexperienced traders.
CFDs are available for trading a range of assets, including shares, forex, commodities, and indices. In addition, CFD trading provides access to more than 10,000 global markets. Although, it is noteworthy that CFDs are not available to US retail investors because of Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulations.
CFDs are potentially high-risk trading strategies, but you can minimise your risk exposure if you understand how CFD trading works. This article provides you with several CFD trading tips, identifying common pitfalls, specific do’s and don’ts that can help you become a successful CFD trader.
Risks of CFD trading – Leverage
The primary benefit of CFD trading is that traders need a small amount of capital to trade. The trading margin can be as low as 1%. This implies that £100 deposited can empower traders to take a position worth £10,000. The lower margin requirement means less capital outlay and greater returns. This is great when the asset prices are moving in your favour. However, if you get the trade wrong, you can end up losing more than your initial investment. This is the leading risk involved in CFD trading.
Traders must be aware of the market volatility when trading CFDs. As per the previous example, a 10% change in price can cause a £1000 gain or loss to a position. On the other hand, a retail investor can deposit £100 and take a £10000 position. Though, they may not be able to sustain a £1000 loss. Thus, it is necessary for retail investors to be cautious and fully understand the risk involved before trading CFDs or they may lose money.
CFD trading tips
There is no secret strategy to double your money trading CFDs. However, specific techniques may enable traders to limit their downsides and become better traders.
Develop your knowledge of CFDs and the market
Before you begin trading, it is imperative to gather knowledge about CFD trading. CFDs are complex financial instruments. Traders should understand the benefits and risks that come with buying a CFD and how CFD trading works. In addition, traders must also possess knowledge about the underlying assets of the CFD they are trading. For example, before trading Forex CFDs one should know the differences and drivers of a GBP/USD currency pair or a EUR/USD.
Hence, it would be wise to begin CFD trading with one or two asset classes that you understand the most, rather than being a jack of all trades and master of none.
Inexperienced traders often make the mistake of acting short of thoroughly researched trades. What is worse is when their recklessness is rewarded by chance, and they earn a profit- this reinforces their faith that trading CFDs is an easy strategy. Therefore, traders must spend time learning trading strategies before they commit to a position.
The ROInvesting Platform is an excellent platform for learning CFD trading strategies through technology, and intellectually crafted online courses, tutorials, articles, e-books, VODs, and individual learning paths are designed to level up any trader beginner professional.
Analyse the markets to time your trades
With developing knowledge of CFDs, it is imperative to decide which type of analysis should a trader use to recognise entry and exit points in the market. Price changes are caused by movements in demand and supply forces that are influenced by external factors. There are two main approaches traders can opt to analyse the market changes, i.e., fundamental and technical.
Fundamental analysis seeks at evaluating the intrinsic value of a security by evaluating various macroeconomic and microeconomic factors. In contrast, technical analysis focuses on historical prices and data to predict the market’s future direction. Traders can deploy a combination of these approaches or use them individually.
Traders must constantly work to better their analysis to become better predictors of the future. The better you get at your analysis, the more likely are you to make lucrative trades. Of course, the best way to improve your analysis is through practice and experience. Nonetheless, it is imperative to understand the theatrical basis for the analysis method chosen.
In addition, traders must be up to date with the current events of the market, be avid readers of financial journals, news, company disclosures and public fillings, government announcements, broker recommendations, white papers etc., to undertake better decisions. The extra knowledge will provide you with the edge and help you identify better opportunities and hopefully make profitable trades.
Build and Stick to a trading plan and strategy
Continuously building on your knowledge and trading goals are qualities of a successful trader. A trading plan comprises a set of rules that govern every aspect of your trading. The plan includes elements such as (but not limited to) entry and exit, risk management, trading goals and position sizing.
It identifies an objective rule-driven decision framework for traders to undertake trades in tandem with their risk appetite and goals, independent of any emotion. So often, retail investors find themselves in uncertain or unknown situations. As a result, emotions such as fear, greed, etc., impact their trading decision adversely. A trading plan guides traders on their future course of action; it tells traders what should be done independently of any emotions.
A trading strategy is a part of the trading plan. It entails the trading style that a trader intends to apply to his trading decisions. Trading strategies include a methodology for entering and exiting a trade, time horizons for trade and tools and indicators that you might use. One can use various methods—news-based trading, scalping, swing trading, day trading, high-frequency trading, etc.
No one best strategy works for all. Rather, the strategy must be chosen in tandem with your trading plan, i.e., goals, risk tolerance, time horizon etc. However, it is crucial to stick to it. The parameters you set will help you minimise impulse to trade on emotion. It is equally important to review and evaluate trading performance to understand if the chosen trading strategy works for you. This can be done by creating a journal that records your winning and losing trades and back-tests your trading strategy against historical data.
Limit your risk with Stop Loss and Limits
One of the most basic and best risk management techniques is attaching a stop and limits to your trading strategy. These predefined your exit level for your trade.
A stop-loss order instructs your broker to close your position if the asset’s price falls below a specified amount of loss. By using a stop loss, traders can protect their capital when the markets are moving against them. This limits the risk and exposure of investors to losing money.
Conversely, limit close order is an instruction to your broker to close your position when you have achieved a certain profit level. It is done to protect your position from sudden volatility in the market prices.
Be aware of your position and risk exposure
The size of the position is the total market exposure of a trade. When making a new trade, you should consider your available capital and the risk you are willing to take on with it. Every CFD trader must identify how much money he is willing and capable to risk on a particular trade.
CFD trading is leveraged. Hence the total exposure that you have to the market is substantially higher than your initial margin. This means that retail investors could lose more money than they commit. It is irrational to think that the price movements will be in your favour as soon as you open your position. If your leverage is high, say a slight 0.1% price movement against you can force you to close your position. Furthermore, you will not be able to profit if it bounces back in your direction.
A good CFD trader takes the necessary steps to be disciplined and operate with strict money management and risk management rules. They take leverage based on their level of certainty, capacity, and trading strategy. They are fully aware and accepting of the risk that they take on with a new trade.
Accept when you make a wrong trade decision
A successful CFD trader understands that no matter how experienced or how good your market analysis is on trade, at some point, you will lose. What makes a trader successful is his ability to accept risks and that he may be wrong more often than he is right in initiating trades. What determines profits and losses are not how and when you trade but how you react or manage your trade once you are in it.
The simple rule is to control your emotions rather than letting emotions control you. One should remain disciplined and aligned with their trading strategy and plan. Traders should view the market objectively, rather than acting out with greed or excitement when winning money or excessively despairing when losing money.
If the price action suggests that traders should change their view on future price movements, they should do so without hesitation. One should not be attached to their position and cut their losses and get out of losing trades when it’s time.
Practice with a demo account
Before you try your trading strategy with real money, you should start with a demo account. This way, you can test your knowledge in actual market conditions without risking any real capital. Then, practice executing trades with virtual funds. During this time, try and test various strategies and see what strategy is best for you.
Open a live account and embark on your CFD trading journey only when you are confident. It is recommended to start small and increase your capital and exposure as you become more experienced and familiar with markets.
Once your real account opens with ROInvesting, you will automatically receive a demo account with a balance of $10k in virtual money, where you can test your trading skills and strategies in a risk-free environment.
How to start trading CFDs Online?
If you are looking to embark on your journey to learn CFD (Contracts for Differences) trading, ROInvesting is a great place to start. ROInvesting is an award-winning CFD broker that allows retailers to trade over 350 assets in 10,000 markets, including commodities, forex pairs, cryptos, stocks, indices on a secure and transparent platform. ROInvesting provides retail investor accounts with leverage up to 1:400 at 0% commission.
Once you start trading, you will discover that trading CFDs are a lucrative way to gain exposure to financial markets with less capital (but more risk).
Hence, it is recommended to always consult a professional advisor before making any investment decisions.
To conclude, what you can control is yourself and what you do when the market’s prices move. Successful traders understand this phenomenon. Consequently, they put equal mastering in themselves and their trading actions and learning fundamental and technical market analysis.