Introduction to CFD Trading
When it comes to soaringly popular financial instruments, you’d be hard pressed to find a more in-vogue instrument than the contract for difference. Contracts for difference, or CFDs, are essentially agreements between a trader and broker on the future price movement of an underlying asset. If an asset looks like it’s going to rise, a trader will buy a CFD based on today’s price, with a view to settling for the difference in price at a later date. Essentially, this means traders can speculate on prices more readily than with other instruments, and with a whole host of additional benefits that arise as a result of the structure of CFDs.
Consider the following basic example of a CFD transaction.
Following extensive research, you identify Company X as being a potential mover. Fundamentally strong performance with high growth might indicate that Company X’s share price has the potential to rise over the short to medium term, so you decide to buy CFDs based on today’s share price. After Company X shares increase in value, the trader can then settle the CFD position with the broker and bank the difference between the opening and closing prices, thus delivering the profit portion on the trade. Unlike futures, CFDs have no natural expiry date, so the position can be held as long as is necessary/practical in order to see the desired outcome.
Basics of CFD Trading
Contracts for difference are fundamentally highly leveraged instruments, because they are traded on margin. This means that traders are required only to front a percentage of the total trade, with the remainder funded by the broker in the short term. This allows trades to be leveraged to the extent that minor market movements yield substantial returns, thus delivering higher profits over a shorter period of time. For traders conscious of maximising their return on capital, CFDs represent a cost-effective way to boost returns, and as a result they have become a staple investment style of institutional investors and trading funds alike.
CFDs are flexible instruments that can be used to speculate on a wide range of assets and markets, in much the same way as financial spread betting opens the parameters of what can be traded, and how. CFDs can be bought in support of a market or position, or sold depending on whether the market is forecast to rise or fall, with equal benefits on both sides of the transaction. This makes CFDs an ideal instrument for hedging risks, diversifying exposure to alternative markets, and generally rounding out a portfolio. With greater transparency requirements on institutional investors, CFDs were found to be traded extensively across a range of markets for this very reason of flexibility, while the substantial returns CFDs can provide can also help shore up the value of the overall trading portfolio.
The upsides of CFDs are unlimited, and with massive leverage coupled with volatile markets, traders can generate serious returns on their capital in a matter of minutes. However, correlatively CFDs are also extremely risky, and the downsides are as equally unlimited as the upsides. In fact, the risks of CFDs are so pertinent that some regulators and regional authorities are expressing concern over the frequency with which consumer investors are pouring their savings into CFDs without due consideration or care. As a result of these not-to-be-underestimated disadvantages, trading in CFDs is always a matter of balancing risks vs. rewards, and each individual trade must be considered firstly from the point of view of the risks posed to trading capital before gains can be taken into consideration.
If you've not yet started trading CFDs, the learning curve can be steep - especially if you start out losing money. CFDs are one of those instruments that are so unpredictable and so bulky that more trades than not will turn out to be unworkable. Even with the best logic in the world, calling the markets is in no way an easy task, and when a couple of points represents the difference between a clear profit and loss in a trade, the issue becomes how effectively losing trades can be mitigated while profitable trades are maximised. In effect, most CFD traders should strive to milk winning trades for every penny, while cutting out losing trades as quickly as possible to protect capital, in the hope that an aggregate profit can be delivered over time.