The Benefits of Trading Contracts for Difference (CFDs)

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Concepts and key issues traders need to know when trading Contracts for Difference (CFDs).

The dynamism of the capital market has impacted all types of assets and fueled demand for financial products utilizing leverage.

Contracts for Difference (CFDs) are financial instruments tracking various underlying assets including forex, stocks, commodities, indices, and cryptocurrencies. CFDs allow you to trade in the capital market using leverage.

What are Contracts for Difference (CFDs)?

A Contract for Difference (CFD) is a financial instrument that tracks the movements of an underlying asset such as stocks, currency pairs, commodities, cryptocurrencies, or indices. It differs from the underlying asset in that you do not need to invest the entire capital to purchase that underlying asset. Instead, you only need enough capital to cover the price change from the price you enter the trade to the price you exit the trade.

This contrasts with a stockbroker who may require you to have nearly all of the capital in your account to buy stocks. In some cases, when you buy a CFD, you may be entitled to dividends issued by the company for the underlying stocks. CFDs can be used to trade in a particular direction, or you can buy one CFD and simultaneously sell another CFD and benefit from the relative change in value.

Does CFDs provide leverage?

Each CFD is associated with a different leverage level depending on brokers and different types of underlying assets. Leverage is a feature that enhances your trading profits as it allows you to increase the amount of capital you can control through borrowing.

For example, some brokers may allow you to buy $4000 EUR/USD while only putting up collateral of $10. To use leverage, you need to open a margin account. Each broker will have different criteria for opening a margin account. They will often ask you questions about your trading experience as well as your investment knowledge.

The important thing to understand is how leverage can affect your trading profits. If you can buy $4,000 EUR/USD using 1:400 leverage, you only need a 0.25% move ($4000 * 0.0025 = $10) to double your capital or wipe out your account. So, leverage is an attractive tool, but it can also be a double-edged sword.

When you open a margin account, your broker will require you to always have a certain amount of capital in your account. Each time you enter a new trade, your broker will require you to put up a specific amount called initial margin. The initial margin requirement is the capital needed if the price of the CFD moves against you, with a larger than usual price change.

Your broker wants to ensure that you have enough capital allocated for a trade that if there is a larger than usual price change, then you have the money to cover the loss. As the market moves, the amount of margin you need to hold for each trade will change. If the price of the asset you are trading moves against you, your broker will take additional margin to cover further losses beyond your initial margin in your margin account. If the price of the stock you are trading is in your favor, then the initial margin requirement will not change, but the maintenance margin will decrease.

The margin requirement calculation is done in real-time, and it lets your broker know the minimum capital you must have in your account to continue holding your trade position. If your trade goes against you and you cannot increase the capital in your account, your broker has the right to start liquidating your position. Make sure you fully understand the margin agreement you sign with your brokers before you start trading CFDs.

Trading CFDs with Stocks

CFDs can be an effective tool for investors looking to trade stocks. The reason is that the leverage used in CFD trading is much higher than the leverage you can get from a stockbroker.

For example, Amazon stock is trading near $1800 per share. This means you would need $1800 just to buy one share of Amazon stock. Many CFD brokers offer leverage of 1:20, allowing you to buy 1 CFD of Amazon for only $90. A 5% increase in Amazon stock would allow you to double your capital. With the same $1800 that allows you to buy 1 share of Amazon, you can buy 20 CFDs of Amazon. Moreover, CFDs allow you to short sell stocks without having to borrow the shares.

Managing your Risk

Trading CFDs can be very risky, especially if you use leverage, so you must have a plan before making each trade. To avoid the risk of blowing your account, you should limit the amount of capital you risk on each trade to 5-10% of your total investment portfolio. For example, if you plan to trade an investment portfolio worth $5000, the maximum loss you should incur per trade would be $500. This will provide you with a relatively comfortable and slow strategy to start with.

Another concept you should adhere to is to adhere to stop-loss and let your profits run. If the market moves against you and hits your stop-loss level, you should exit and wait for another trading day. If the market moves in your favor, adjust your stop-loss point and let your profits increase as the market moves in your direction.

Summary

Contracts for Difference (CFDs) are financial instruments that allow you to trade in the capital market without owning the underlying asset. CFDs track underlying assets and provide leverage to help you increase your profits. These underlying assets include stocks, commodities, indices, currencies, and cryptocurrencies. To trade CFDs with brokers, you will need to open a margin account. Although leverage can significantly increase your trading profits, it is a double-edged sword and can also lead to significant losses. You must have a carefully considered risk management plan for each trade before risking any of your hard-earned money.