Nigel has been in the regulated financial services industry for nearly a decade, has previously owned a financial brokerage and has written many times for sites relating to personal finance and trading.
In traditional forms of trading on the markets, the basic approach for success has always been ‘buy low sell high’, which means that money is made when an asset such as a share on a stock exchange rises in value. Of course, this doesn’t just apply to stocks and shares, as various commodities and bonds also operate in exactly the same way. However, what this simple method means is that there has to be a rise in value for a profit to be made. Consequently, if the price of the asset that has been purchased falls, then there is a loss and sometimes these can be substantial.
In contract for difference trades, there are several big advantages to be found over this simple buy/sell process, not least of all in the fact that CFD traders can make money when assets actually fall in value. This is called ‘short trading' or taking a short position.
Of course, ‘going short' isn't only available to CFD traders as other forms of derivative trading such as options and futures can also be used to make a profit in this way. The term ‘derivative' means that the trade doesn't involve the actual purchase or sale of an underlying asset, but the difference between CFD and older forms of derivative trades basically come down to flexibility.
In both options and futures, the position is taken over a fixed time frame, which means that a specific date or time is chosen for the trade to close right from the start. With contract for difference, the trader chooses when to close the position, which gives far greater flexibility in terms of holding a position that might prove to be even more profitable over a longer time period or closing one that threatens large losses.
Stop loss orders
Strategy for trading means far more than simply working out how to take a position at the right time, it must also include a risk management approach that is suited to each individual trader or investor. Although having a more flexible working basis than other derivative trades, CFDs can still be open to large losses, especially as they are a leveraged product which allows traders to take large positions with a fraction of the capital outlay that might otherwise be needed.
Thankfully there are built-in tools such as stop-loss orders which can and should be used in CFD trades. Essentially, these are limiting points that are chosen when a trade is opened, and which guarantee it will be automatically closed if a certain point or situation is reached. Although this doesn't mean that CFDs are immune from being loss-making, it does mean that limits and safeguards can be put in place quite easily that offer protection from catastrophic failure.
Taking a short position should not be confused with short-term trading, which is something else entirely, but also provides a major part of the attraction for CFDs. Once again, financial instruments such as futures and options operate over long-time frames which means that profits or losses are delayed. So-called ‘day trading' has long been a feature of the stock exchange around the world, where more volatile shares have been targeted for quick turnarounds. As CFD trades are based on the fluctuations in value of any asset, they can be applied to a wide range of difference markets and are perfectly suited to work on an extremely short time frame, be that minutes or even seconds.
Evaluating short-term price movements within a specific market is one of the key skills needed to become a successful CFD trader. Different strategies can be employed to try and gain an edge, and tried and tested evaluation methods such as technical analysis can be used to great effect.
Take emotion out of the equation
CFD trading differs from other forms of trading and investments in another extremely important area. For some traders, especially those involved in stocks and shares, having some form of 'emotional involvement' is part and parcel of their investment strategy. This can range from buying assets that are ‘ethical' or ‘green' to supporting new developments which might have a personal connection in some way. It can also mean simply using knowledge accrued from experience in other areas of life and making trading choices based on a ‘gut feeling' that something will work out to make a profit.
When it comes to CFDs, this approach can lead to losses. Quite simply, any emotional attachment to a trading position that has been taken can lead to extending, or holding, that trade open for too long. Hoping that a situation can turn around can lead to margin calls on leveraged products such as CFDs, and that can be a fatal economic blow in the worst scenarios. By taking emotion out of the equation and using data and knowledge of CFD trades built up by experience, a more objective frame of mind can be used to make successful trades.
The idea of emotionless trading is one of the reasons that forex markets are so popular with CFD traders, and within that sector, why the interest in cryptocurrency markets is so high. As well as being something of an abstract asset to choose that offers little or no opportunity to become emotionally involved in outcomes, forex markets can also be very volatile, which is good news for contract for difference trades.
Due to the fact that when asset values fall CFD traders can still make money, it is obvious that taking emotion out of the decision-making process is key to success, and that choosing volatile markets such as forex pairs is also a good idea. With so much real-time data available online for forex exchange rates, these markets are fertile ground for making a profit from CFD trades whether that involves taking a short or long position or even using the option to hold a position open for longer.