What are CFDs (Contracts for Difference)?
Learn CFD trading strategies and how this financial instrument can be used for speculative purposes or hedging.
What is CFD Trading?
A contract for difference or CFD, is a tradable instrument where the client agrees to exchange the difference between the opening and closing price of a contract with a broker. CFDs are known as derivatives products in the financial trading arena.
Traders never actually take possession of the underlying financial instrument being traded – it is simply a contract between two parties. The CFD follows the price movements of the underlying asset.
Positive returns are realized when the asset moves according to the position taken. Traders use these financial instruments to initiate trades based on real-time price movements. With CFDs, traders can take speculative positions on the market, irrespective of the direction of the underlying markets.
CFDs are a popular instrument for hedging purposes; they provide an option to offset losses when investments sour. You have the option to take a short position and gain when prices fall.
CFD trading has become increasingly popular around the world, particularly in the United Kingdom. There are thousands of markets available to traders with many enjoying the widespread exposure that CFD trading offers.
CFD Trading in Action
Let us assume that the ask price of XYZ stock is $30 and you decide to purchase 100 shares. The total cost of this transaction is $30 x 100 shares = $3,000. If you were using a broker with a 50% margin, you would need to pay $1,500 upfront for the trade.
However, when you trade XYZ stock with a CFD broker, the margin requirement is significantly less – around 5%. That translates into 5% x $3,000 = $150 up front. This is one of the many benefits of trading CFDs over traditional methods.
If XYZ stock appreciates and the bid price reaches $31, you would be able to sell it for a total profit of ($31 – $30) x 100 shares = $100. In percentage terms, the profit is calculated as follows: $100/$1500 = 6.67%.
Now let us take a look at what the profit would be trading CFDs. When the stock is trading for $31, the CFD bid price may be $30.95 and that is the price you will receive if you want to sell. A few cents in profit will have to be relinquished with CFD trading, and the gain will be calculated as follows: ($30.95 – $30) x 100 shares = $95. In percentage terms, the profit is calculated as follows: $95/$150 = 63.3%.
It is possible that you will be required to buy the CFD at a higher price, but the returns are still positive and similar to what they would be with traditional trading when a higher margin is used.
Owing to the high fees, brokerage commissions and other costs associated with traditional brokers, transaction fees for CFDs are typically lower, giving traders an advantage when it comes to trading large volumes. Therein lay the many benefits of CFD trading.
You can speculate on the price movement of markets by taking a position and gain when the markets move in the direction of your forecast.
Hedging against losses is often touted as one of the reasons why CFD trading is so popular, and here is why this holds true. If the markets are falling, you will want to protect the value of your investment portfolio from further losses.
One way to do this is by going short on your CFD trades. With CFD trading, you will be able to secure gains if you sell your underlying asset and the price declines during the contract period. If the underlying asset’s price rises, you will incur a loss. For all intents and purposes, a Contract for Difference shares many similarities with Forex trading.
The Benefits of Trading CFDs
Among the many benefits of trading CFDs is the higher leverage offered. For the most part, CFD leverage starts with as little as a 2% margin. This figure is wholly dependent on the underlying asset being traded.
In this vein, you can trade a wide range of commodities, stocks and indices. The amount of capital outlay is positively correlated to the margin requirement. With higher margins, the initial outlay will be higher and vice versa. A caveat is in order with high leverage: profits can be magnified, but so can losses – so careful analysis of market conditions is always advised.
Since there are typically thousands of potential markets that you can tap into, CFD trading provides a wide range of derivatives options to traders. Since there are no short selling rules, you have the option to short any financial instrument anytime you please.
The costs associated with shorting or borrowing are absent since you do not take possession of the underlying asset. As a CFD trader, there is always the option of day trading. Conventional markets may impose restrictions on your trading activity with daily trade limits or minimum capital outlays and stamp duties.
With CFD trading, it is possible to open an account with a minimum deposit of $1,000. Many of the same order types are available with CFD trading, including: stop-loss, take-profit, limit orders, and others.
Guaranteed stops may be available for a nominal fee, but overall there are substantially better fee arrangements for trading CFDs. Brokerages generate profits by way of the spread. You must pay the ask price when you buy and you must accept the bid price when you sell.
Gold and Silver Trading
Gold is a precious metal that has been used for trading and investment purposes for thousands of years. It is perceived as a store of value and it has many applications in production, jewelry and other uses.
While the Gold Standard was in effect, currency units could be exchanged for an equal value of gold. After the Gold Standard was abandoned, currencies were allowed to ‘float’ on the international markets to find their own equilibrium values. The price of gold is closely correlated with the USD. In fact, there is an inverse relationship between the U.S. dollar and the gold price.
When the financial markets are experiencing high volatility, investors flock to gold to hedge against a market downturn. Alvexo provides you with many gold trading facilities. Since gold is traded against the U.S. dollar, the trading symbol we use is XAU/USD. XAU is Latin for aurum and it is the term used to denote gold bullion.
One of the biggest drivers of the gold price is interest rates. Bearish sentiment creates an atmosphere conducive to the gold market and inflationary fears always bode well for gold investments.
Silver is also a precious metal popular among commodity traders, traded in quantities of 1,000 ounces. We use the following designation when silver is traded against the U.S. dollar – XAG/USD.
AG is a derivation of the Latin word argentum. Silver has tremendous potential as a commodity and its practical applications are widespread. This metal shines in recessionary times and during times of economic booms.
CFD Trading Strategies
Whether you are trading stocks, indices or commodities, the same set of rules apply to CFD trading. An in-depth understanding of your underlying asset will serve you well as you forecast future price movements. Below is a checklist of the most important tips for trading CFDs:
· Conduct research into the types of tradable assets you’re looking to invest in
· Establish a strategy and test it in a demo trading account
· Stay abreast of the latest news developments as it relates to your underlying assets
· Manage your risk profile effectively
· Look for an edge in your trading activities
· Control your leverage
· Use a mix of technical and fundamental analysis in your trading activity
· Diversify your portfolio
· Maintain a CFD journal to record your trading activity
· Establish stop-loss and take-profit points
· Maintain discipline throughout and avoid emotional trading