Unless you’ve traded a CFD before, they might as well stand for “Confusing Financial Doodads” such is the confusion around the subject. However, once you understand what CFDs, or rather, Contracts For Difference are and how they work, trading them is a lot less technical than it may first appear.
To gain a more comprehensive understanding of CFD trading and the potential advantages associated with using them, we have outlined exactly what CFDs are, as well as a step-by-step breakdown on what you need to know to begin trading them.
1. Trading CFDs – what are they?
Contracts For Difference, known as CFDs, are tradable instruments that mirror the movement and direction of the underlying product without having to actually own the asset. These can be a commodity, share, index, currency or cryptocurrency. Essentially, a CFD is a contract between two parties to settle the difference between the opening price of the CFD instrument and the price it closes at.
Profits or losses are realised when the underlying asset moves in relation to the position taken.
Depending on whether you think the price of a financial asset will go up or down, you can buy or sell a number of units of a particular instrument. For every point the price of the instrument moves in your favour, you will gain the point movement x the number of units you have traded long (up) or short (down). Likewise, for every point that the price moves against your position, you will lose the point movement x the number of units you have traded long (up) or short (down).
Trading CFDs allow you to not only profit from upward trending markets (but also downward trending markets)
Traders are able to determine which direction they predict the market will go (i.e. up or down) and trade accordingly.
It is always important to remember that trading CFDs is a leveraged product, meaning that you have more buying power at your disposal to truly capitalise on your investment. Therefore, although potential profits are significantly increased, potential losses can also be exacerbated. This is where a strong risk management plan is essential!
Learn more about writing a successful trading plan now! Read our 6 essential steps for developing a successful trading plan.
2. Buying Long vs. Selling Short
If you believe the price of a financial instrument will rise, you buy long and profit from every movement in price increase. On the other hand, if you predict that the price of an instrument will fall, you sell short and profit from every movement the price decreases. If the market does not move in the direction that you had predicted, then the result will be a loss.
Going long (a BUY trade) is typically the route that the majority of traders take, where they buy long positions in stocks, indices, commodities and the like. They then hold them for a period of time and hope that the market moves in their favour so they can obtain a trading profit.
CFDs, however, are generally fast moving and the pricing of CFD instruments can often change rapidly. It is therefore unlikely that you will hold your position for significant periods of time. This is why buying long and selling short can both be highly advantageous methods of trading.
3. Margins and Leverage – what are they?
Margins are essentially the initial deposit required to open and hold a CFD position, and the amount of margin required varies depending on the tradeable instrument. The required margin needs to be available in your TradeDirect365 account prior to opening the position. It’s expressed as a percentage of the value of the underlying position and is dependent upon the volatility and liquidity of the instrument being traded. For instance, TD365 has a 0.5% margin requirement on the Aussie 200 Index. To trade a $1 per point position, you’d need just c., $30-40 on your account to open the trade. To view a full list of our margin requirements, please click here.
Margin requirements can be limited via the implementation of stop-loss orders on our trading platform. If a stop-loss order is put in place, then the initial margin requirement will be equal to the amount that would be lost if the stop order was actually triggered.
In traditional stock trading, you are required to pay the total value of the stock you wish to purchase, directly to your broker. For example, Brett wants to purchase 10,000 shares and the current value of that share is $15. In traditional share trading, Brett will have to pay $150,000 which is the total value of the shares purchased (10,000 x $15).
CFD trading, however, operates using leverage. You are therefore only required to deposit a small percentage of the full value of the underlying instrument in order to open your desired position. This allows you to gain exposure to the price movements of that CFD instrument and potentially enter larger positions than what might normally be possible. It is important to note that CFD trading carries risk. Losses are also leveraged and can result in you losing more than your initial investment if you don’t have a good risk management plan in place.
4. The Advantages of Trading CFDs
Trading CFDs provides investors with much higher leverage than conventional share trading does. Leverage offered by some CFD brokers can start as low as a 0.20% margin requirement. The lower the margin requirement, the less capital you are required to outlay and the greater the potential returns. However, again, it is important to remember that increased leverage can also significantly magnify potential losses.
Online CFD trading provides you with access to the liquidity in the underlying market as well as the liquidity offered by your CFD provider.
Trade Long or Short
Investors are able to profit not only from an upward trending market but also from a downward trending one. This allows you to adapt to the market and invest accordingly. Want to know how to read candlestick charts to improve your trading strategies? Read our guide here.
International Market Access from One CFD Platform
CFD brokers provide access to a wide range of securities from the world’s financial markets so investors can trade many markets all from the one CFD platform.
Array of Trading Opportunities
Online CFD trading provides investors with an array of trading options including stocks, currencies, commodities, cryptocurrencies and indices. For a complete list of TradeDirect365’s products, view our Market Information Sheet.
CFDs Mirror The Underlying Security
In some instances, such as when you trade options, market sentiment can significantly sway the cost of trades. When trading CFDs, however, they typically mirror the exact price of the underlying security. With regard to equity CFDs, that also means you receive a positive dividend adjustment if you’re holding a long position. However, if you are holding a short position, you receive a negative dividend adjustment from your broker. Learn how to read the markets with our step by step guide here.
5. The Disadvantages of Trading CFDs
Potential Losses May Exceed Initial Deposit/s
Leverage works as a double-edged sword; it allows you to capitalise on a favouring market by increasing your buying power. However, it can also end in significant losses that may exceed your initial deposits, resulting in you actually owing money to your broker.
Risk of Trade Closure
You must ensure that your trading account has sufficient funds in it at all times otherwise, if your account balance falls below the required margin level, your broker reserves the right to close your open positions.
High Market Volatility
Global financial markets can often fluctuate frequently as a result of high market volatility in which the pricing of CFD instruments can directly reflect this. This may result in the prices of CFD products moving quickly from one price to another and therefore it may not be possible to execute an order in between the two prices. Stop-loss orders can be affected by this and may result in the execution of a stop-loss order at an unfavourable price to where you initially set it.
Overnight Funding Costs
When holding long CFD positions overnight, traders incur a funding cost, however if you’re holding a short CFD position overnight, you should receive a funding rebate from your broker. For more information on funding costs, refer to our Product Disclosure Statement (section 13).
CFD Trading: The Bottom Line
Trading CFDs provides an array of advantages, from trading a wide range of global instruments from one trading platform, to being able to trade either long or short, lower deposit requirements than traditional stock trading and using leverage to enter positions that a trader may not have otherwise been able to enter.
However, it is important to be aware of the risks involved in trading CFDs. It is very important that when using CFDs to trade the financial markets, you only trade with funds that you can afford to lose.
Choosing the right CFD broker is also paramount to success. Look for one who doesn’t charge excessive fees and wide, variable spreads. Find out how you can tell if your CFD broker is ripping you off with our comprehensive framework here.
Want To Learn More About CFD Trading?
Then you should check out our Secrets of CFD Trading section which includes a range of educational articles, including;
- 3 easy steps to start online trading
- Five Important Tips for Ambitious Traders in 2018
- 6 essential steps for developing a successful trading plan
- The benefits of CFD trading vs. shares
What Markets Can I Trade Using a CFD Platform?
There are quite literally thousands of financial instruments to trade via a CFD trading platform. At TradeDirect365, you can trade the following markets;
- Indices – trade 13 of the world’s largest indices, including the Australia 200, UK 100, Wall St 30 and the Japan 225
- Stocks – we offer over 400 ASX stocks and several hundred stocks from the US, UK and Europe
- Forex – 30+ currency pairs, including majors like AUD/USD, EUR/USD & USD/JPY
- Commodities – trade Gold, Silver, Brent Crude oil and US Light Crude oil
- Cryptocurrencies – trade Bitcoin, Ethereum and Ripple