What is CFD trading?
CFDs are a form of derivative trading. These Contracts for Difference allow you to generate favourable returns on price movements of financial instruments without actually owning the underlying asset.
CFD Trading in a Nutshell
If you’ve ever wondered what CFD trading is all about, you’re at the right place. CFDs are Contracts for Difference. These derivative financial instruments allow you to open positions on a wide range of assets without actually owning them. CFDs mirror the price movements of the assets in question, but they don’t confer ownership interests in the actual assets themselves. They are derivatives because the price of a CFD is derived from the price of the underlying asset.
As a trader or investor, you can easily open a position on forex, commodities, indices, stocks, or other financial instruments in a CFD format. It doesn’t matter what the current price point of the asset is – CFDs can be traded in rising or falling markets. CFDs are regarded as short-term financial instruments. They are volatile and risky. At any given point, CFDs present traders with two options. You can buy the CFD or sell the CFD. If you choose to buy the CFD, you adopt a bullish position, with an expectation of a price rise in the future. If you choose to sell the CFD, you adopt a bearish position, with an expectation of a price fall in the future.
An example will help to put things into perspective. Let’s assume that you wish to trade gold CFDs. Assuming that the current price of gold is $1813 per ounce, and you believe that current market volatility will result in gold price appreciation. In this case, you buy the gold CFD hoping that the price will rise by the time you sell it. This is known as going long. If your analysis leads you to believe that stocks will rise and the price of gold will fall, you will short gold CFDs. This means that you expect the price of gold to drop. The closing price determines whether your trade finishes in the money or out of the money. Two possible situations can arise:
- If you buy gold CFDs and the price increases when you close the position, your profit is determined as follows: (The price increase X the position size) – (broker fees, commissions, and charges). If you buy gold CFDs and the price decreases when you close the position, you will incur a loss.
- If you sell gold CFDs and the price increases when you close the position, you will incur a loss. If the price decreases when you close the position, your profit is determined as follows: (The price differential X the position size) – (broker fees, commissions, and charges).
CFD brokers generate their income through the spread. This is the difference between the buy price and the selling price on assets when you open a CFD.
Popular CFD Markets
As you already know, CFD markets are readily available. Pretty much any financial instrument can be traded in a CFD format. This includes currency pairs, commodities, indices, and stocks. CFDs can cover thousands of markets, varying in size and scope by the broker that you choose. You could trade Alibaba stock, S&P 500 index, NASDAQ composite index, gold, Brent crude oil, and the GBP/USD currency pair, among others. There are many possibilities with Contracts for Difference.
As a trader, you can make use of a wide variety of indicators for comparative purposes, trend analysis, and analyzing price direction. Let’s consider several important technical indicators that traders use in their daily trading regimens.
- Bollinger Bands – Bollinger Bands are extremely useful technical indicators that are great for revealing volatility in the financial instrument. There are upper bands, lower bands, and simple moving average bands. When prices move towards the upper band and exceed it, the market is overbought (breakouts). When prices move towards the lower band and exceed it (breakouts), the market is oversold. Expect a rebalancing of prices. When prices stay around the simple moving average band, volatility is low.
- MACD – Moving Average Convergence Divergence measures 2 different moving averages. When the moving averages converge, the market will likely reverse. When the moving averages diverge, the market begins to slow down.
There are many useful technical indicators that can be incorporated into your daily CFD trading activity. These include SMAs (simple moving averages), EMAs (exponential moving averages), Ichimoku Cloud, Relative Strength Index (RSIs), and many more. Each of them has a specific purpose and usage in the financial markets.
How to Trade Stock CFDs
Stocks are priced according to a host of factors, including demand and supply considerations, macroeconomic variables, geopolitical events, company financials, et al. A detailed analysis of the stock in question, the economy, and various economic indicators provides traders and investors with valuable information. Technical and fundamental analysis is used to determine whether stocks are overpriced, underpriced, or priced right.
For trading purposes, it’s useful to consider the company’s financial reports as a starting point. Dividends, strategic growth plans, market capitalization, and expert analysis (upgrades, downgrades, valuations) can provide traders with valuable market insights. By combining this data, it is possible to speculate on the future price of stocks. If financial performance exceeds expectations, stock prices can rise. If financial performance falls short of expectations, stock prices can fall.
Tips for Trading Stock CFDs
When assessing potential price movements in stock CFDs, consider the following:
- Gross Sales
- Dividend Yield
- Debt/Equity Ratio
- Return on Equity (ROE)
- Earnings Per Share (EPS)
- Total Shareholder Return
- Return on Capital (ROC)
- Price to Earnings Ratio (P/E)
- Dividend Payout Ratio (DPR)
Benefits of Trading CFDs
CFDs are risky financial products. These Contracts for Difference use leverage to multiply the trading power of your capital. The higher the leverage, the greater the risk. With CFDs, you can multiply your profits when trades finish profitably, but you can also magnify your losses when they don’t. Fortunately, there are many benefits to trading CFDs, notably:
- Leveraged products – Traditional stocks, commodities, indices, and other assets require traders to post all the money for the trade upfront. With leveraged products, traders are only required to front a percentage of the total trade value. Leverage allows you to open much greater positions than your available capital allows. This can work in your favor when trades finish profitably. The converse also holds true.
It’s really important to read up as much as possible on macroeconomic variables that influence market prices. The more you know, the more informed your trading decisions will be.
Fortunately, CFD brokers understand that traders don’t want to lose more than the available capital in their accounts. That’s why negative balance protection is implemented. This prevents you from going into a negative balance if trades close out unfavorably. You can also determine the amount of leverage you feel comfortable with, and limit yourself to those amounts. This is known as a risk mitigation strategy.
One of the most exciting benefits of leveraged products like CFDs is the ability to trade in rising or falling markets. With traditional stocks, the asset price must appreciate for profits to be generated. But with CFDs, you can short stocks, commodities, indices, or forex and profit accordingly. When you short CFDs, you sell the CFD up front and buy it back later at a cheaper price (provided the CFD closes at a lower price).
Another lesser-known benefit of CFD trading is hedging. If you hold a position in traditional investments and you expect the price to drop, you could hedge against a drop in the price with a CFD on the same financial instrument. For example, if you hold gold stocks and you expect the gold price to drop, a short sell gold CFD could work in your favor!
Ready to get started? For all of these reasons, it may be worth your while to consider CFD trading.