What is CFD trading and how does it work?

CFDs are complex financial derivatives that are used for trading in share markets. Before we provide you with skill tips and trips for honing CFDs, let us first know what is a complex financial derivative actually, how they are traded and how one earns profit from them.

This article will give you a whole sole idea of what is CFD, what are the types of trading in CFD, best CFD brokers in 2020, risks involved in CFD trading and what are the pros and cons of trading via CFDs.

So, keep going through this exciting article and polish your skills for becoming a CFD trader.

What is CFD? – Complex financial derivative aka contract for differences, as this is a derived product; hence, it is named so. CFD deals in values derived from other assets.

Learn more about CFD definition

The change in the prices of an underlying asset reflects the difference in the CFDs value. For example, if you have a share of Tesla and the price of shares soar. It will imply that the value of the CFD will also increase.

People like to invest in CFDs due to its high leverages. Here leverages mean one has greater exposure to its underlying asset compared to its invested price. Hence the profit earned when the prices go up is relatively high. Likewise, the losses are also very high when the prices suddenly tumble down due to market fluctuations.

Why use CFD instead of securities? 

• Trading charges are comparable – in some countries, the trading charges for CFDs are comparatively low then the typical stocks and securities like in Europe, an investor from the UK need not pay duty charges for trading, and that’s how it works as a cheaper option.

• You can grasp more about market movement – compared to an average retail investor; a CFD trader can imaging it pretty quickly where the market is moving. i.e. if one knows that the market slide is a downside, then he can short his underlying derivative assets.

• The product portfolio is bigger than to securities – if an investor invests in securities then he has fewer options available for long term investments whereas a trader who trades via CFD has a wide range of future and forward contracts like bonds, equities, shares, ETFs, commodities, and cryptocurrencies.

• The comfort of placing small trades – In CFDs, one can place short trades to get instant benefits which are not possible with an underlying consolidated asset. This is all because of its derivative nature.  

Here the trade size can be limited to a couple of dollars, but in long-term investment, it could be starting from several thousand dollars. 

• Benefits of leverages – Using this quality of CFD can fill his bag with income that is ten times investing in an individual share.

It can be cleared with an example: suppose a person buys a CFD stock of Tesla whose price is of $100, but the leverage is 10% hence the stock for him would be of $10 and suppose if the cost of the share goes up by 9% than the CFD stock profit would be of 90% and the normal stock profit would be 9% only.                                                                                                                            

The flip side of investing in CFD is that if the share price of Tesla’s share is reduced to 10%, i.e. if it incurs a loss and now priced at $90, then the loss would be negative 90% and not 10%.

So one can clearly understand that there is a vast difference in profit earned and loss undergone hence CFDs are termed as a very risky instrument of trade, and they come with a warning that around 74% of the total CFD traders experience a hundred per cent loss.

How to master CFD trading?

Here are some useful tips on how to become a pro in CFD trading?

• Try on a demo account – Avoid the panic to overshadow your confidence, do some practice on a demo account and get yourself handy with actual market ups and downs. Using a demo account will boost your confidence, and you will learn to implement how the strategies are implemented and what are the results of specific strategies. Also, you’ll know how to use tools of a given broker appropriately as per requirement. 

• Go on a live account – Now, after gaining all the knowledge and experience in the demo account, it’s time to start on a live platform. So, open your account to start trading. But make sure you take your time and do not haste while arriving at a trading decision. Seek advice from experts or any of your friends and family members who have been through the situation before. They will teach you awareness of the financial market. 

• Charge your account – Fund your demat account for trading. It is highly recommended that you start with little money to do trading. In CFDs you are having the facility of leverages, so you don’t need to actually fund your money with a big chunk, avail the benefit of leverages.

• Set leverages according to your assets – there are many brokers like ROinvesting, HFTrading is providing flexible leverages, but some others do not offer adjustable leverages.

As per the recommendations of trade pundits and experts, if you are playing in CFDs, then the leverages levels should be put according to assets suppose if you are using higher capital, then leverage could be placed at a high level but conversely if you are singing a lower-valued asset then should be kept as low as possible. This practice is to be followed to hedge the risks of more significant losses. 

• Use perfect strategies– Without implementing strategies, you are indeed susceptible to face losses in CFD trading, but with the preplanned strategies implementation, you can avert your chances of undergoing losses. Instead, you will win with a much higher reward.

 Strategies could be any like day trading, scalping, intraday trading or swing trading. But they should be used with indicators to have an eye on market scenarios consistently. Besides, you should place a back-up plan in case things go awry and do not support your agenda.  

• Use the volatilities in your favour – Forex markets are always subjected to volatilities; one should be able to grasp where the market will go after some time.

If one thinks that the market is going to yield at higher prices, then he can go holding his derivatives for a long time. 

And if one thinks that the market is going to observe a downfall the selling short is the best option before It goes below the previous trends or support levels. 

• Use protective orders – one should positively use stop-loss orders to hedge the total loss risks. And if someone wants to avail the price of stop-loss orders, then he can use double stop-loss orders. 

Placing put orders is also an excellent option to get affirmative about your profit. If someone feels that the market could face a downfall, then in that condition, he/she can place a put option order to insure it by paying some money as a premium for the assets. 

Some experts also use stop-loss points and stop profit points as these points are showing the extension of market trends. These points are beneficial concerning the past trend. Now, these are used to set beyond support level and resistance level. 

Using these points, one can sell short or play long. For example, if the market prices are losing below the support level, then one can sell his/her derivative assets before it incurs into a total loss. 

And the stop profit points are used in a way that if prices are going to sore shortly and beyond resistance level, then it should not reach up to that situation where execution occurs. 

Execution is a situation where no buyer is available to buy the share, and hence due to this also one may incur a loss; therefore, using these points is also helpful for gaining desired profit. 

• Be ready for a rainy day – It is the game of margins that you may fall short of your money. One should be prepared to face the problem of slippage, aka the rainy day in a slang manner. It means you do not have the funds to place the trade due to lack of a sufficient amount of money.

So, It is recommended to inflow a sufficient amount of money in your account. 

• Do not overtrade – Overtrading is just the same as over speeding. One should pay attention that doing something more than enough leads to a downfall or a problematic scenario.

Overtrading is very injurious to your capital. Place only that much order that you can afford losses. Otherwise, you could fall off from this trading market due to lack of money and depression. It generally sprouts from the greed of earning more or recovering the lost wealth. But often, people forget to apply strategies before making a bid, and that culminates into further losses. 

What are the available tradable instruments in CFDs? 

There are several tradable assets available in CFD trading. These include stocks, forex, stock indices, commodities like metals, grains, oil, energy etc. and options and cryptocurrencies.

One can choose his niche and invest according to his interests. But again, there comes strategy; one is recommended not to put all the eggs in a single basket. i.e. one should increase his portfolios by choosing more than one derivative as this will decrease the risks of getting losses. 

But alongside it is also prescribed to invest in small amounts to avert any possibilities of incurring a loss.

• Risks involved in CFD trading – According to the FCA’s consultation paper, it is mentioned there that more than 80% of investors in CFD lose their money. Out of five, only one lucky person gets the profit.

So let us discuss the risks involved in CFDs.

• Counterparty risk – – We have learned that CFD contracts for differences. It is a contract between two parties in which one party agrees to pay the money in a redecided date in exchange for underlying assets.

Have you thought of a condition when the other party refuses to oblige the contract, what will happen in that case – A total loss? So, there always is a possibility of a breach of the agreement. 

• Scam brokers – One should be aware of scam brokers. Because you are investing your hard-earned money in a very volatile market, so a scam broker can loot your money and make you bankrupt.

One should check whether a central authority of that country regulates a broker or not. An investor should always invest with a broker who has a profitable industry existence and who is abided by financial rules of that country. Also, the amount of time spent by a broker in the market testifies its veracity of work. 

So, to do this, you can choose broker reviews on reputed manly websites.

• Slippage – Slippage means you have placed a 100-dollar trade in four parts each of $25 and after placing (it takes time) you see it is showing or trading for $26, but you don’t have $104 on your account so you could not place the trade at the right time.

 So, to avert this situation, one should take care of slippage and keep an eye on the trade placing timing.

Bottom line about CFD Trading

So, in this article, we have come across and covered various aspects of CFD trading on how it benefits traders and what measures investors should take to roll out their methods for trading. Always remember that complex financial derivatives are the riskiest trading instruments; Hence one should carefully invest in these instruments and do all the research and examination of financial markets and take a deep dive in them before investing in these types of portfolios.

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