This guide outlines the key CFD trading and investment strategies you should be aware of.
CFD trading: overview
A contract for difference (CFD) is a financial product that allows investors to speculate on the price movements of an underlying asset without actually owning it. CFD trading enables brokers to open a position in which they can predict whether a security’s value will rise or fall.
But how do you make money as an investor? Simple. You get the difference between the stock’s opening and closing price. CFD provides leveraged exposure, enabling you to put down a small percentage of the total trade value. On the other hand, it may amplify your losses if the market moves against you.
Like any other investment type, they come with certain risks that need careful evaluation. Here are some CFD basics and tips to help get you started.
How does CFD trading work?
Getting a hold of the nuances and mechanics of contract for difference is crucial to investing wisely. At the core of this scheme is to make educated guesses on price direction and amplify exposure through leverage. It would help if prospective investors learn CFD trading first before dipping their toes in this financial instrument.
Long vs. short positions
When you open a ‘long’ position, that means you’re anticipating a price increase. So, you’ll start buying. Doing so allows you to open trade at its current price and close it at a higher value. Conversely, you’ll suffer losses when the price falls, and you exit for less than what you paid on opening.
But you can still make money by adopting a ‘short’ position. If you predict the asset’s value will decrease, you must sell. Doing so will shield you from losing funds as values decline. However, if the holding prices rise instead of decline, you’ve made a wrong price bet, leading to losses.
How you’ll earn
Either way, you can collect profits by correctly predicting security price fluctuations. First, you must deposit funds to cover margins, which change based on your exposed position size and current market pricing.
Unlike other schemes, you don’t have physical assets to exchange, so the opening and closing trade prices are settled in cash. The net difference between these prices is sent through the investor’s account in a specific brokerage firm.
CFD trading brokers and platforms
An account can be opened through CFD brokers and financial institutions like banks. Brokerage firms are intermediaries for listed companies that sell their securities. These third-party entities often have trading platforms you can use for CFD-related activities.
To build an investor’s skills in opening and managing positions, they also offer demo accounts, allowing users to practice extensively before committing capital. They can also offer additional services, like investment advice and consultancy, and provide useful resources when researching market and price movements.
How to evaluate CFD investment opportunities
As CFD trading contains inherent complexity, you should thoroughly research how they work before investing. Poor understanding exposes you to risks of unnecessary losses. For instance, in 2020, CFD trading clients in Australia lost over USD$ 774 million within five weeks, prompting the government to install stricter measures to regulate brokers and providers.
To assess the risks and rewards of CFD, one must:
- Study the underlying asset and its volatility
The asset underlying a CFD plays a huge role in its overall performance profile. More liquid assets like stocks, foreign exchange, indices, and commodities tend to demonstrate intraday volatility that’s easier to study and analyze. On the contrary, illiquid assets can have unpredictable and wild price swings that make profitable CFD positions harder to achieve. That said, gauge an asset’s typical price fluctuations and volume to determine position sizing and risk exposure.
- Match investment options with your trading preferences
Even experienced traders need to pick their CFD battles wisely to play to their strengths. For example, an intraday trading scalper has a different mindset than a buy-and-hold investor. Consider whether your investment preferences lean towards shorter-duration volatility or long-grinding trends.
Beyond this, consider whether an index or forex CFD aligns with your trading hours and activities compared to a single-stock CFD. Also, consider how round-the-clock availability impacts your stamina and investment management style.
- Leverage rate and margin requirements
High leverage ratios, reaching 500:1 in a few cases, may look tempting for controlling large CFD positions with very little upfront capital. But note that if your predictions don’t go as planned, losses can spiral out of control just as quickly. That’s why in more regulated markets like Australia, the leverage rate is capped at 30:1. This means you can trade up to AUD$ 30 for every dollar of available margin.
While reduced leverage lowers the barrier of entry cost-wise, don’t underestimate margin requirements, either. You still need to set aside minimum account balances to withstand any adverse positional moves. A prudent investor knows how to balance elevated leverage with risk tolerance and capital.
- Determine spreads, fees, and commissions
Spreads, which cover the difference between the CFD buy and sell prices, vary across brokers and assets. Meanwhile, some providers charge a fee when taking or liquidating a position. These costs directly reduce your profit potential. Compare these rates across all firms to ensure your profits remain intact.
Look for commission-free CFD trading to avoid exchange fees. Commodities and indices often fit the bill; you only need to pay the spread. Watch for hidden charges like account inactivity fees or minimum trade requirements that further erode your bottom line.
- Liquidity and contract rollovers
A particular CFD’s trading volume determines the availability to enter/exit positions quickly. Underlying assets with tight spreads and active trading, for instance, generally have high liquidity. Meanwhile, less liquid markets have wider bid-ask spreads and price slippage.
Another factor to consider is how the broker handles contract rollovers (renewals). Automatic rollovers with price deviations can generate unexpected trading costs.
- Platform capabilities
Does the broker’s platform offer the tools essential for productive CFD trading? At the minimum, look for real-time pricing, customizable charts and indicators, order types like stops/limits, and seamless mobile functionality.
Advanced traders may also seek more complex features like automated trading and virtual private server or VPS hosting services. Furthermore, ensure platform reliability, especially since a system slowdown during volatile markets may lead to missed entries and exits.
- Funding and withdrawal options
Reliable CFD brokers offer convenient deposit/withdrawal methods tailored toward their client base. Wire transfers, e-payments, and major credit cards are typically available with reasonable clearance times. Confirm funding security as delayed withdrawals or rigid holding periods place account capital at undue risk.
- Regulation and reputation
The government is tasked to accredit and regulate brokers in jurisdictions like the UK’s Financial Conduct Authority (FCA) or the Australian Security and Insurance Commission (ASIC). Additionally, strong client reviews validate quality service over years of operation. These denote safety for trading capital and indicate fair business practices. On the contrary, substandard regulation raises the probability of internal risks.
Going back to Australia’s massive CFD trading crash in 2020, the ASIC instituted reforms in the sector that led to a 91% reduction in aggregate net losses, from AUD$ 372 million to AUD$ 33 million in one quarter.
- Evaluate the broker’s financial health
While a broker’s regulatory status shows they meet certain financial standards, it pays to dig deeper into their books. That said, watch out for red flags that may signal shacky finances. Think of frequent leadership changes, low cash reserves, and market maker revenue to turn a profit for each quarter.
A broker in financial straits could spell trouble for your capital if bankruptcy hits. Your open CFD profits or account margin could be frozen or tied up in legal proceedings around client fund segregation. So, check the firm’s earning statements and credit ratings as part of your smart investment strategies. They signal stable operations and lessen the likelihood of folding unexpectedly.
Final words
Jumping into CFD investing without caution and due diligence is a recipe for losses, primarily if the leverage is misused and unchecked. Therefore, do your homework and evaluate product risks.
Study how underlying asset volatility exposes you to losses, the broker’s fees and reliability, and whether your personality fits an active CFD trading’s requirements.
Remember, knowledge always precedes effective CFD trading. However, the best traders didn’t get there before learning the ropes. So, immerse yourself in the market, scrutinize contract specifications, and get a handle on platform tools.
Develop proper knowledge and risk management skills before establishing a CFD portfolio. Sharpen your approach instead of chasing ‘get-rich-quick’ schemes. With the right foundation, CFDs can become a tool for long-term investment success.