CFD Trading Example
Rather than committing to physical ownership of an asset, a CFD trader speculates only on its upward or downward price movement. Let’s assume the trader selects a stock that has an initial valuation of $40 per share and the trade composed of 200 shares is executed. On a traditional stock market position, the cash outlay for the trader would be $8,000 (plus any other trading commissions or fees required by the broker).
To circumvent such large cash outlays of money, a CFD broker can offer some key advantages for traders (especially those with smaller account sizes). In many cases, CFD brokers have required trading margins of only 5%. In other words, this would allow the trader to enter the position with an initial cash outlay of just $400. Of course, the exact amount will vary depending on individual trades opened and the specific commission charged by the broker. For an intraday trader with a small account size, this is a scenario that offers an excellent opportunity to make money.
At the time a trade is opened, CFD trading accounts will display initial losses that are equivalent to the size of the trading spread. Thus, a spread size equal to five cents will require further gains of five cents in order to reach its break-even point. Assuming the stock moves higher and reaches $42.50 per share, the position would result in gains of $250 (or 6.25%). However, the CFD price is generally lower than the price shown in the national exchanges because long traders must close the position at the Bid price (which might be $40.48). In this example, total profits for the CFD trader would be $248 (contract difference of $2.48x 100 shares) and this would be equal to a gain of 6.2% on the position.
Profiting in Bearish Markets
Many beginner investors are often surprised to find out that it’s actually possible to profit from the bearish price decline of an asset. Another benefit of CFD trading is that it allows investors to open positions that profit as the underlying asset drops in value. This is referred to as “going short” the CFD (as opposed to “going long” as we covered in the trading example).
Let’s say a CFD trader wants to speculate on a position and believe that the share price of Apple, Inc. (NASDAQ: AAPL) is going to fall. The CFD trader could sell a “share CFD” based on Apple stock. Once executed, the CFD trader would be in a position to exchange the difference between the opening price and the closing price. This position would earn a profit if the share price drops and would generate losses if the share price of Apple stock gained in value.
CFD Trading Strategies
CFD trading approach must be supported by an effective strategy that has proven to be consistent over time. There are many factors involved which must be understood when constructing positions and developing an approach to the CFD trading market. Here, we will look at some of these factors and see how they can be used in active markets.
Long-term vs. Short-term: One of the most essential aspects involved with the tasks of mastering CFD trading is to determine a time frame that will be used for each position. In many cases, this becomes a fluid situation as it is entirely possible that a CFD trader will wind up holding a position longer than originally intended. This means CFD traders will often revise the time frame that might have been chosen for the position. However, it’s still important to have a sense of some of the differences present in opposing time-based strategies.
Short-term trading allows investors to generate profits based on changes in market prices on small time frames. Sometimes referred to as “day trading” or “intraday” trading, short-term price changes are generally based on time frames that stretch from several hours to a few days. When trading in CFDs, it is possible to see sizable price changes even during these short periods of time and this can create substantial opportunities for profitability.
Long-term trading refers to periods that stretch from several days to several months (but can even last for years, in some cases). Some CFD traders prefer long-term time frames because the strength of extended price trends can often be predicted with greater accuracy. Long-term strategies in CFD trading often allow market participants to capture price moves that are much larger in size because these trends tend to unfold over months or years. Essentially, the larger sizes in long-term price moves create opportunities that are more substantial when compared to short-term strategies).
Swing trading strategies: Swing trading strategies aim to benefit from intermediate price reversals (price “swings”) that become visible in market trends. Of course, prices cannot move in one direction forever and CFD traders often notice small corrections or retracements within a dominant market trend which offer opportunities to enter into new positions.
For example, in bull market trends, asset prices will need to face periods of retracement or consolidation. This will cause prices to fall below trend highs. These types of events give CFD traders another opportunity to go long and buy into the uptrend at favorable valuations. Under ideal scenarios, the bullish momentum found in the underlying price trend will continue in the positive direction and the CFD trader will be able to accumulate profits as it happens.
Breakout trading strategies: Breakout trading strategies involve situations where market prices have broken above key resistance levels or have fallen below key support levels. The advantage of breakout strategies is that it’s relatively easy to spot new trading opportunities and forecast the direction of the next price trend. When resistance levels break, uptrends are generally expected and long CFD trading positions can be opened. When support levels break, downtrends are expected and short CFD positions can be opened. The downside of this approach is that volatility levels tend to rise in these scenarios, and this is often viewed as being unfavorable for CFD traders with a more conservative outlook.
Protective CFD Strategies: Stops & Limits
Protective CFD strategies allow traders to secure gains while limiting any potential losses in a position. Beginners and experienced CFD traders should always employ stop losses or limit orders so that excessive losses cannot accumulate in the event of unexpected market volatility. Stop losses and limit orders play an integral role in risk management strategies for CFD traders. Once the proper risk tolerance levels have been structured (usually potential profits will equal to 3x potential losses), stop orders can be submitted so that the position will be closed if prices reach pre-defined levels. An added benefit of these protective order strategies is that they allow traders to execute decisions without monitoring a trading station. As a result, stop orders work as one of the best security decisions CFD traders can make when positions are open in active markets.
Overall, it should be understood that there are several elements involved when trading in CFDs and each of these elements must be treated with importance. Failure to adopt anyone of these trading elements can create unnecessary problems and significant losses in the event market volatility performs in an unpredictable fashion. Before starting to use real money in open positions, CFD traders should always practice first with a demo trading account in order to learn the basic functions of each broker’s unique trading platforms.
Trader Summary: CFD Trading
- A Contract for Difference can be defined simply as a trading contract that exists between two parties (a buyer and a seller).
- CFDs positions can be based on a wide variety of asset classes, including: stock shares, stock shares, commodities, forex pairs, or cryptocurrencies.
- CFDs give investors an opportunity to speculate on the potential trend movement that is likely to unfold in the price of a market asset.
- CFD trading can be conducted without actually taking ownership of the asset involved in the market position.
- CFD trading also allows investors to open positions that profit as the underlying asset drops in value (short-selling).
- CFD trading strategies involve the use of several approaches which include swing trading and breakout trading. These two strategies tend to be particularly useful when dealing specifically with CFD markets.
- Protective CFD strategies (stop losses and limit orders) allow traders to secure gains while limiting any potential losses in a position.
- Several elements are involved when trading in CFDs and each of these elements must be treated with importance. Failure to adopt anyone of these trading elements can create unnecessary problems and significant losses.
- Before starting to use real money, CFD traders should always practice first with a demo trading account in order to learn the basic functions of each trading platform.