Updated on January 21, 2023
A contract for difference in stock market trading is an agreement between a buyer and a seller which clearly stipulates that the buyer must pay the seller the difference between the present value of a financial asset and its value at the contract time. CFDs are useful financial instruments that can help even beginner traders achieve their trading goals.
A CFD is a derivative instrument that enables you to place bets on a wide range of global markets like forex, commodities, indices, and shares without actually having to own the underlying asset. For instance, if a trader believes the euro will strengthen against the pound, they might choose to go long on the EUR/GBP CFD. If the euro gains 1% against the pound, the price of the CFD will also increase by the same percentage.
CFDs are leveraged products, meaning you can access a position by simply putting down a small deposit, known as a margin. Your profit or loss would then be calculated based on the full size of your position, which is why it is important to remember that although leverage can magnify profits, it can also magnify losses.
Whether you’re a novice or seasoned trader here’re a few tips you could follow when trading CFDs.
Building a trading strategy
Like all other types of trading, CFD trading requires knowledge and expertise to minimize losses and maximize potential gains. Before you embark on this trading journey, your trading goals and strengths must be clear to you. The following factors should be considered in depth before embarking on your trading journey;
- Time commitment
- Trading goals
- Risk appetite
- Risk management strategies
- Markets to trade
- Trading strategy
- Record keeping
Each of these factors will present differently from one trader to the next, so it is imperative to be clear before putting any money down.
Stay loyal to your CFD trading strategy
A trading strategy is basically the set of rules you will use to achieve your trading goals. It outlines your particular trading style; are you risk-averse or risk-prone, do you only invest in stocks, or do you love the diversity that comes from playing in multiple fields? Your trading strategy also outlines your methodology for entering and exiting trades and the tools and indicators you plan on using.
You might opt for numerous trading styles depending on which strategy you choose- including day trading, swing trading, and scalping. The importance of staying loyal to your trading strategy cannot be over-emphasized. Sticking to your trading strategy will minimize the impulse of trading our of fear or greed. Additionally, it’s also important to be aware of when your strategy isn’t working and when a pivot might be necessary.
Constant Research and Reading
One of the most important behaivours to develop as a CFD trader is conducting constant research on the stock market, companies, plus micro and macro environmental factors. Investing is essentially a game of knowledge; the more you know, the more likely you will win big. Although there are many resources that can help you make trading decisions, some trading signals can only be identified through extensive experience and in-depth information. Theoretical knowledge and practical experience will leave you in a great position to make money while CFD trading.
Study the market to time CFD trading
When building your CFD trading strategy, it’s essential to decide the type of analysis you will use to identify entry and exit points in the market. Traders utilise fundamental and technical analysis to predict market movements before placing their bets. Fundamental analysis places its focus on external events and macro-economic factors that could have an impact on a company’s stock price. In contrast, technical analysis attempts to predict the future direction of the market by analysing historical data.
Understand your position size or total exposure
Before opening a new position, you must be clear about your entire portfolio, the amount of capital you already have laid out, and the amount of risk you’re willing to take on. A CFD trader should ensure they outline precisely how much capital they are ready to risk on each trade in their trading plan- and be comfortable with the fact that it also represents how much money they could potentially lose.
It’s also important to remember that CFD trading is leveraged; therefore, your total position size will always surpass your initial deposit, and you could lose more than you commit in a single trade. Therefore, a common approach is to only risk a small percentage of your capital on a single trade and manage your risk with stops and limits.
Leverage is an important part of trading CFDs. Increasing the size of transactions in order to increase potential gains can be extremely dangerous if poorly executed. However, a cautiously leveraged portfolio can have you enjoying the best of both worlds- exposure to the high potential gains offered by leverage on aggregate, with a cautious enough strategy to safeguard capital resources. This means strategies like leveraging only to gear up your transaction capital as opposed to scaling up your entire account, which would be too risky, and backing positions that have become winners more heavily to maximize yield. Leverage is a powerful tool to use but must be applied sparingly.
Manage CFD trading risk with stops and limits
One of the most common strategies is to hedge your bets and protect your investment. These pre-determine the exit levels for your trade and help ensure you don’t lose your investment. A stop-loss order is an instruction to your broker asking that your trade be closed at that is less than the current market price. The first question you need to ask yourself is: ‘how much money am I comfortable losing on this trade.’
You can also choose to place a limit close order, which closes at a level just above the current market price. This closes your trade after you have achieved a certain profit level, with the intention of protecting your capital from adverse market conditions.
Unlike in spread betting, where all costs are transparent, CFD trading carries hidden costs whose implications you must know and understand. With CFD trading, a number of trading costs must be considered depending on varied factors like the makeup of your transaction, your broker’s fees, platform commissions, and more. This is especially true for traders considering holding a CFD position for over one day- the daily increasing financing charges quickly mount up and can become a significant problem later.
Start small, then diversify your trading
CFDs are excellent tools to expand your trading experience and increase your horizons because they grant you access to declining and rising markets. Like most things in life and investment, it is wise to start small, learn and then increase your investment over a period of time. CFD traders are also advised to diversify their investment to mitigate risk but also increase their profit potential.
Monitor your open positions
Even after creating many stops and limits in place, you must frequently review your positions. This will ensure that you quickly identify any issues or opportunities and act promptly whenever necessary. You must also make sure you have sufficient capital in your account to cover the total maintenance margin required to keep each position open. If your account falls below the minimum fund requirement level, you will be placed on margin call, and this could result in your position being closed if you don’t top up your account.
A strategy used by many traders is to download a trading app and use it to monitor their different positions.
Never add to a losing trade
In order to become a successful CFD trader, you must know when to cut your losses and move on from a trade. The rule is to maintain focus and stick to the trading strategy you set at the beginning of your trading journey. Once you notice there’s nothing more to be made on a trade, and before you step outside your trading strategy, cut the investment.
Practice using a demo account
For novice CFD traders who might be market shy initially, a great way to practice is through a demo account. A demo account provides the opportunity to experience live markets in a risk-free environment for free.
As you take the time to explore the demo account, make sure you gain an understanding of the financial terms used and the markets that you have access to. If there are things you don’t understand, there are many trading courses online that you could take to sharpen your skills.
With these tips and techniques, even the most inexperienced CFD trader can win every once in a while. Like most other stock market plays, every trader must only gamble what they are willing to lose and should remember that nothing is guaranteed in stock market trading.
This might also interest you