Understanding Contracts For Difference
If someone told you that there is a bakery where you get “dough” but no physical delivery, you would probably say WHAT! However, with CFDs, you might be able to make some dough without taking physical delivery of the underlying asset.
But, you have got to be careful, as CFDs can make profits disappear faster than a rabbit in a hat! You must be wondering how random all of this is.
Don’t worry, we won’t do any magic tricks nor feed you any dough. Rather, we will talk about what a CFD is, how you can trade it, and hopefully make some “dough” in the process.
Besides making profits, we will also discuss the risk factor of CFDs and talk about some of the ways you may want to manage the risk of trading CFDs. We will discuss some strategies that could be used when trading a CFD and how you can go about selecting which market to trade CFDs in.
Sounds good? Then let’s dive right in.
What Exactly Is A CFD?
CFD stands for contract for difference. It is a trading instrument that allows a trader to trade an underlying asset without actually taking (or giving) delivery of that asset.
CFDs are cash-settled and the trader earns a profit or loss of the difference in the trade-opening and trade-closing price. Besides the price-settlement factor, the major benefit of trading CFDs is leverage.
CFDs are leveraged instruments which means that a trader can take a position worth a large amount by paying a fraction as a margin. Depending on the leverage ratio offered to the trader, a trader can put up as little as 5% or 3% of the money needed to take a trading position.
For example, if a trader wants to buy 1,000 shares of Nvidia shares priced at $400, the trader would have to pay $400,000. However, if an Nvidia CFD is available with a leverage ratio of 10:1, the trader only has to put up $40,000 to take a position worth $400,000.
You might wonder how this can boost returns. If Nvidia goes from $400 to $440 (a 10% move), The value of the trader’s position goes from $400,000 to $440,000. It is a profit of $40,000 on a capital of $40,000.
But, consider what happens if the price falls by 10%. The value of the position goes down to $360,000 and the entire $40,000 put up by the trader is lost. So, leverage is a double-edged sword that needs to be handled carefully.
Selecting The Right Market For Trading CFDs
Now that you know how extreme CFD trading can be, one very important question to answer is which market to trade CFDs in. Our suggestion is to pick the market that you best understand.
If you are good at following the US markets and understanding the actions of the Federal Reserve, then it makes sense to trade an S&P 500 CFD or a Dow Jones index CFD. If you closely track a company, say Apple or Amazon, then you may want to trade an Apple or Amazon CFD.
The idea is to pick a market that you understand and about which there is plenty of information freely available to you. It is through this information that you will update your knowledge about the market. If you don’t have access to or are not aware of the nuances of the South African stock market (for example), then you probably should not trade a South African index or stock CFD.
You also may want to consider the volatility of a specific market. Is that level of volatility compatible with your style of trading and your psychology? Are you someone who relishes high volatility or do wild price moves make you fearful?
Lastly, you may want to analyze the liquidity of the market or asset that you wish to trade. Wanting to close a trade but not being able to do so due to a lack of buyers/sellers or putting up with a high bid-ask spread can erode significant returns or even cause losses. Being able to enter and exit trades without high impact costs is important for any trader.
Some Basic Trading Strategies For CFDs
Conceptualizing strategies to trade CFDs is similar to conceptualizing strategies to trade stocks or indices or commodities. You can try looking at your preferred technical indicators like the moving average.
For example, if the 20-day moving average crosses over the 50-day moving average, you may consider going long or buying CFDs. If the price falls below the 200-day moving average or if a shorter-term moving average goes below the longer-term moving average, then you may consider going short or selling CFDs.
You may also study the price action, find important levels, or use indicators like the Fibonacci retracement. When the price gives you a signal at an area of value, you may consider going long or short as your analysis may indicate.
You could also backtest the price data of certain assets and try to find patterns like what happens on a specific day of the week if the previous day was up or down. If you can find any pattern or behavior, you may try to trade that with CFDs.
Any kind of trading comes with risk. In order to manage such risk, you may want to think about your stop loss levels and position sizing. You may also want to know what your risk-reward ratio is for each trade and what the maximum amount is that you are willing to lose.
Once you know your maximum loss tolerance, you can work out the number of CFDs that will keep your possible losses within that limit. Staying on top of the market with alerts is also a useful thing to do.
Cerus Markets specializes in CFDs and covers a variety of markets including stocks, indices, commodities, and cryptocurrencies. If you think you are ready to trade them, then our 100% welcome bonus offer for new sign-ups is a great way to begin.