Updated on January 21, 2023
Estimated reading time: 10 minutes
A contract for difference (CFD) is an agreement between a buyer and a seller that states clearly that the buyer must pay the seller the difference between the current value of an asset and its value at contract time. CFDs give traders and investors the opportunity to make profits off price movements without necessarily owning the underlying asset. Keep reading the guide on “CFD Trading For Beginners”.
A CFD does not consider the asset’s underlying value; the contract only recognises the price change between trade entry and exit.
How it works
A contract for difference (CFD) represents an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product between the contract opening and closing time.
This trading strategy is mainly applied by experts only. A CFD trader never actually owns the asset in question but receives revenue based on the asset’s price change. For instance, rather than own physical gold or Wheat, a trader would simply speculate on the possible price movements.
Investors use CFDs to bet on the price movements of an asset. If the trader purchasing a CFD notices an asset price increase, they will offer their holding for sale. The net difference between the purchase and sale prices could represent a win for the trader.
On the other hand, supposing the trader has reason to believe that the asset’s value will drop, an opening sell position can be placed. To close the position, the trader would purchase an offsetting trade. The net difference would then be a loss settled through their account.
Advantages of CFDs
CFDs offer higher leverage than regular trading. Standard leverage in the CFD market is typically subject to regulation; it was formerly a 2% maintenance margin (50:1) but is now 3% (30:1 leverage) and could go as high as 50% (2:1 leverage). The lower the margin requirement, the less capital outlay a trader needs and the greater the potential for returns. However, increased leverage could also result in higher losses for a trader.
No shorting rules
Some markets have rules to prevent shorting and require the trader to borrow the instrument before short selling. A few others have different margin requirements for short and long positions. On the other hand, CFD instruments can be shorted at any time by the trader.
CFD brokers can offer many of the same order types as other brokers, including stops, limits, and contingent orders, such as “one cancels the other” and “if done.” A few brokers offering guaranteed stops might charge a fee for the service or find another way to recoup costs.
Brokers make their money when the trader pays the spread. Occasionally they charge commissions or fees. Therefore, in order to buy, a trader has to pay the ask price, while to sell or short, a trader ought to pay the bid price. The spread’s size largely depends on the volatility of the underlying asset.
No Day Trading Requirements
Certain markets would require minimum amounts of capital to day trade or place limits on the total number of day trades that can be executed within certain amounts. However, the CFD market does not experience such restrictions, and all account holders can day trade if they want to.
CFDs can be traded in stocks, index, treasury, currency, sector, and commodity markets. This enables speculators interested in diversity to trade in CFDs as an alternative to exchanges.
Disadvantages of CFDs
Traders pay the spread
Although CFDs offer an attractive substitute to traditional markets, they also come with potential risks. One of these is the fact that traders have to pay the spread on entries and exits, which could eliminate potential profit from small moves. The spread also has the effect of decreasing winning trades by a small amount compared to the underlying security which would then increase losses by a small amount. Therefore while, on the one hand, traditional markets expose traders to fees, regulations, commissions, and higher capital requirements, CFDs cut down on traders’ profits through spread costs.
Weak industry regulation
There isn’t a lot of regulatory oversight in the CFD industry. A CFD broker’s credibility is often based on reputation, longevity, and financial position as opposed to government standing or liquidity.
CFD trading a fast-paced and requires close monitoring. Traders should keep this in mind and be aware that there’re lots of risks associated when trading CFD. There are liquidity risks and margins that must be observed; if you cannot cover reductions in values, your provider may be forced to close your position, and then you’ll have to meet the loss no matter what subsequently happens with the underlying assets.
How to Start CFD trading
The first step to beginning CFD trading for beginners is to find a broker. The best CFD companies usually offer demo accounts with virtual funds, with access to the same markets and features as actual live accounts. This allows traders to practice trading strategies with real market data without the risk of losing capital. They are also an excellent way to try different platforms and decide which works best for you.
They’re different platforms for CFD trading, leaving the choice at the trader’s discretion to decide which to use. A user-friendly and reliable platform will receive top choice among traders. Depending on the frequency of trades to be performed, you might choose Meta Trader 4 or Meta Trader 5. These platforms are popular in the day trading industry and supply a holistic range of features and tools.
Typically, opening a CFD trading account is free. However, CFD brokerages make the bulk of their money through spreads, commissions, margin losses, and small fees for holding overnight positions called swaps. A few brokerage companies will charge you deposit and withdrawal fees. It’s important for traders to remember that they might be required to maintain a minimum deposit or minimum trade size.
It is important to check and ensure the trading platform you sign up to has a dedicated customer support team; otherwise, the risk of losing your capital is very real. Many typically offer a 24/5 live chat service, which you can confirm on their website.
CFD Trading Strategies
The Long Buy
If you, as a trader, believe the price of an asset will increase, you might want to “buy” or open a long position. When investing in CFDs, it’s important to remember that you are buying the underlying asset position and not the actual asset. For instance, if the price of gold per ounce is $1,400 and you have reason to believe it will increase, your broker could offer a margin of 5%, and you could buy a CFD for 100 ounces. If you had bought the asset in full, the cost would have been $140,000, but because you are investing in a CFD, you’d only pay 5% of the total.
You can calculate the profit you would earn or the loss you would suffer by working out the difference in unit price between the current price and the opening price, multiplying it by the number of units (in this case, 100 ounces). In this case, if the price of gold increased by $100 to $1500, you will have made $100 x 100 ounces, totaling to $10,000 and vice versa.
The Short Sell
The short sell is simply the opposite of the long buy. In this case, you are borrowing an asset from a broker to sell it off, then buy it back, and return it at a lower price later down the line. Once you close your position, the asset returns to the broker, and you keep the difference in cost. This strategy is best followed when there is certainty that the price will lower.
Suppose the price of gold is at an all-time high of $2,200 an ounce, and you have information that it will tank soon. You could open a short position using a CFD for 100 ounces of gold at that same price with a margin of 5%. This position would cost you $10,500 (5% of $220,000). If your bet works out and the price drops to $1,900, your final profit would be $20,000 ($200 multiplied by 100 units).
Trading tips commonly used by beginner traders
This is a strategy commonly used by day traders, with the idea being to make a high volume of small, profitable trades in a single day. This strategy allows a trader to spread add up their profits over a number of trades while simultaneously spreading their risk. Scalping is a unique way for beginner traders to get a taste of the action without taking too much risk. The disadvantage of this technique is that it requires concentrated time and dedication to practice.
Long Term Trading;
Due to the fact that CFDs have no expiration dates, they can often be held for long periods of time. However, it’s important to remember that you could face charges in the form of changing interest and overnight holding fees. Therefore, it is important to calculate your estimated costs beforehand.
With this trading technique, you only pay a percentage of the total price of the asset (the margin), leaving your broker to lend you the rest. Other instruments can be traded with leverage, but CFDs offer particularly low margins. Margin (or leverage) trading of CFDs increases both your profits and your losses. With this technique, you open a position greater than your capital outlay. The margin is recorded as a percentage (for instance, 5%), and leverage as a ratio (1:20). For instance, if shares in company X cost $200, your broker might offer a CFD with a 5% margin, for which you would have to pay $10 per share. If your broker offers a CFD with 1:20 leverage, you would need to pay one-twentieth of the total price: 200/ 20 = $10.
CFD trading can be rewarding for both novice and experienced traders; however, like all other trading instruments, the risk is inherent and must therefore be carefully considered before participating.
Conclusion on CFD Trading For Beginners
CFD trading can be a great way to make money, but it’s important to understand the risks involved. Make sure you do your research and start with a small amount of capital to get started. Sign up for our newsletter to get more tips on how to trade successfully.
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