CFDs are popular but majority of traders are not totally aware of its benefits and risks. Therefore, you need to understand the CFD concept, if you wish to dabble in it and turn into a better trader.
Leverage products mechanism.
Generally, CFD trading provides leverage with ratio 10:1. It means for each $1 you are exposed to CFD worth $10. Thus, a small amount of cash provides significant leverage.
You get the freedom to speculate share price movement but will you receive profit or have to pay for losses can make a huge difference. For example, you assumed that share prices of Moltentop Company will increase from $16 to $18, so you open a long position with 1000 CFDs.
CFDs opening position value – 1000 x $16 = $16,000
If price of underlying share rises up to $18 –
Position value when price increases 1000 x $18 = $18,000
Profit earned will be $18,000 – $16,000 = $2,000
It means with $2 increase, you earned ten times. Unfortunately, if prices had fallen down you would certainly have lost ten times. Thus, with CFDs you can earn profits ten times faster, but can lose ten times quickly.
CFDs mean you don’t buy physical shares. However, you get exposure to physical share price movements. Therefore, if you lose than at times your capital gets affected and you need to pay extra. Therefore, along with benefits consider the risks and strategies to mitigate them.
Benefits of CFDs
Trading leveraged instrument accompanies risks along with benefits.
- Cost effective because you trade on margin
- Flexible because you trade on price action without physically owing the share
- Ability to earn from both fall and rise markets
- Trade variety of financial instruments like shares, commodities, indices, futures, etc.
- Receive dividends and participate in stock splits
- Apply hedging strategy, when share price fall is expected to reduce or remove risk
- Exposure to 24-hour trading in global markets
- Use stop loss order to minimise the loss
Important CFD trading principles to consider
Generally, CFDs trade length is between few days and weeks, so there is a need to consider several aspects.
With CFD trades never use all the available capital. It is advised that trade just 10% of total capital, especially on products with leverage because risks are high.
Acceptable position size needs to be determined first, so check share prices and calculate the risk you will take instead of analyzing how much leverage the capital will give. For this analyze your stop loss and then calculate the amount you will possibly lose, when you stop. If the amount is more than your tolerance level then narrow position size. Determine an amount, which is within a tolerable risk level.
Entry & exit rules
Time decay does not affect CFDs, so apply entry rules, which are similar to trade shares. However, when leveraged product trades are in question the exit strategy is crucial. It needs to be managed diligently for quick exit in case market moves against your prediction. Always remember that price move in any direction up or down gets amplified by 10:1 ratio.
CFD trades need to be monitored regularly to ensure that exit is made, when there is high probability of changes in market direction. There is no rule for exit signal in CFD trades because exit too late or too early can dramatically affect your losses and profits.
Stop loss helps to protect your capital. Stop loss limit for CFD trades need to be considered minutely. Stop loss set for share is not applicable for CFDs because it can turn out to be costly. CFD is leveraged, so money can be lost significantly at the rate of 10:1.
For example, a 4% fall in share price can cause a 40% reduction in trade capital. Therefore, set capital, which is near enough to shield the capital amount, but far enough to allow trade to spread out. Remember not to use automatic stop losses, especially when you trade with market makers.