In recent years, CFD trading has increased drastically. The interest in this efficient form of trading has grown larger and larger where many have switched from traditional stock trading to CFD trading instead, but what is CFD? below you will find all the information you need to understand CFD trading basics.
CFD is an abbreviation for Contracts for Difference. It is a financial derivative instrument that reflects the price of an underlying asset, e.g. a stock, commodities, currencies or an index. When you buy a CFD, you trade on the change in the underlying asset price, but you never own it.
A CFD reflects an underlying stock or an index, and when you buy a CFD, you do not buy the physical stock but only a reflection of its value. It works like a contract. CFDs also have a built-in leverage effect, which means that only a certain percentage, a collateral requirement, of the total value of the underlying asset is required to buy. You do not own the underlying asset directly when you buy a CFD. Instead, you own an instrument that tracks the price of the underlying asset’s price.
Open a CFD account
Below, CFD brokers meet the following essential requirements:
- Secure management of your capital-all CFD brokers are regulated to be able to operate in Europe and some also, according to the Swedish Finance Inspectorate
- Low trading costs with reasonable prices.
- A good customer reputation is essential for CFD brokers and then, preferably from traders worldwide.
- The CFD broker should have excellent, accessible customer service with communication 24 hours/5 days a week.
What is a CFD contract?
A CFD (contract for difference) is a contract drawn between two parties, a buyer and a seller. You open a contract at the present value of an underlying asset, such as a share or cryptocurrency. It acts as a reflection of the fair value of a share. It is not the share itself but a representation of the value of the share. If the value then goes up and down, the difference is paid out. If the value goes up, the seller pays the difference, and if the value goes down, the buyer pays the difference. In recent years, trading in CFDs has increased significantly and become very popular with investors.
A CFD can have different expiration dates; it depends on the underlying financial instrument. Some CFDs have no expiration dates, while others may have a one-month or one-quarter validity period. When the period expires, the difference must be paid out.
You can also trade CFDs and exchange them for other financial instruments such as stocks, commodities, bonds, commodities or currencies.
How does CFD trading work?
So how do you go about trading CFDs? With CFD trading, there are few restrictions on which underlying assets can be traded, which means that access to the global market is very open. A CFD provides leverage, which means that you only need to invest a small part of the total value in trading with CFDs. This means that there is a slight margin requirement. Because you trade on margins, your profit can multiply multiple times, but your loss can multiply multiple times, which means you can lose more than you invested.
When you are dealing with CFD trading, you talk about spreads. This is the difference between the purchase price and the sale price. We advise monitoring the spreads of various shares, securities and other goods traded within CFDs.
There is also a holding cost that is calculated every day, and for every open account you have, you may have to pay this cost. The holding cost can be both positive or negative, depending on your position and the exchange rate that the holding cost has for your particular account. For some CFDs, you also need to pay commission, but this does not apply to all CFDs. You should also take a closer look at the price before trading a specific CFD.
When you are doing CFD trading, you can profit from it both if your CFD increases or decreases in value. For example, if you think that a share price will decrease in value, you can sell a CFD before and then buy it back at a lower price.
CFD Trading Strategies and Methods
Want to know how to get started with CFD trading and what strategies you can use to make money? Here you can read more about this. Perhaps this is the most crucial step to getting started and making money on CFD trading.
Comparison between stock trading and CFD trading
Let’s take an example where we compare a purchase of a stock with a purchase of a CFD that has the same underlying stock.
For example, if you want to buy a share from company ABC, you become a shareholder, and in this way, you also get certain rights in the company. You can also get a return depending on whether things are going well or poorly for the company.
Company ABC sells shares for $10 each. If you want 100 shares with the company, then you need to spend $1000.
When you buy a CFD contract, you are trading with margins. If, for example, we then again want a CFD with company ABC and the margin is 5%, then the deposit is $50 instead of $1000. If the underlying share’s value rises, the profit increases multiples of the margin. The gain will therefore be much more significant if the share increases in value. If it had decreased in value, the loss would also be multiple, and you could thus lose more than you have invested. Between 70-80 percent of all non-professional clients lose money on CFD trading.
Pros and Cons
The advantage of trading CFDs is that you, as a buyer or investor, can have the opportunity to make money when, for example, shares increase or decrease without actually buying the underlying share. Because the trade is by a margin, the profit can also be considerable. Let’s take a closer look at how it works.
The leverage effect for CFD trading
A significant advantage of CFD trading is that the leverage is significantly much higher than it is for traditional trading. The margin for CFD trading can start as low as 2% and go up to 20%. Because the requirements for margins are so low, less capital needs to be invested from the start, and there is a greater chance of getting a high return. If the leverage increases, the losses can also be higher. CFD contracts are complex instruments that involve an increased risk of rapid losses due to leverage.
When you trade CFDs, you use something called margin requirements. The collateral requirement is a percentage that indicates how much of the position’s total value is reserved by your capital. Let us assume that you want to buy 100 shares in company A, where each share costs SEK 10 each. Traditionally, you buy 100 shares for SEK 10 each, which means you need to have SEK 1,000 in your account. If we assume that the collateral requirement in the CFD for company A is 5%, this means that you use SEK 50 (1000 * 5%) of your capital to invest SEK 1000.
Thus, the security requirement enables you to place more on the market than your account is worth and thus create leverage.
If the value of the share then rises by 10% to SEK 11. How big will the return be then?
-Traditional trade: Bet SEK 1,000. Win 100 ISK. Return 10%
-CFD trading: Bet SEK 50. Win 100 ISK. Yield 200%
Reliable CFD brokers
companies that offer CFDs needs to build a good reputation and trust in their customers to increase their credibility. Before opening a new account with a CFD broker, you should examine the company’s background and history. Do your research and make sure you know who and what you are dealing with before you start. you can check this best UK CFD brokers list.
Tips for CFD trading
There are many tips and tricks you can learn to get a successful result in CFD trading. A lot is learned simply through experience. You can use tips shared by other traders who buy and sell CFDs daily. So what are their recommendations?
- Do not follow the market trend.
- A tip that many have shared is that you should not follow the trend. When many people begin to invest in long positions, successful traders look for reasons to place short positions. In many cases, the general population is wrong, and, therefore, it is better to look for other opportunities. This does not mean that you should go against everyone else, but it is simply a matter of analyzing one step further.
- Trust your instinct instead of being persuaded.
- A classic is that your friends or someone around you try to convince you about the “next big thing” in the trade. It can be good to hear other people’s perspectives but do not let it convince you against your instinct.
- Back if you are unsure.
- You do not have to feel that you have to shop and act every day. If you are uncertain of a trade or how the market will turn around, take a step back and analyze instead of acting drastically. The most successful traders have developed a great deal of patience where they read the market instead of trading fast to fear losing their investment.
- Analyze the underlying property.
- Take your time to learn about trade CFDs and what relationship CFDs have with their underlying assets. Find similarities and differences between a CFD and its underlying property to understand better how it works.
- Learn to review your own decisions.
- If you have won three wins in a row, do not become too confident but take a step back. If you have three losses in a row, don’t lose hope; instead, analyze what happened and learn from your own mistakes.
- Start carefully.
- If you have just started a CFD trading contract, start small! There is no need to invest all your life savings right away. Instead, start by learning about the market. Start small so that you can handle the loss if it goes wrong.
- Focus only on specific markets.
- There is no point in starting to invest in everything you see. Instead, divert your thinking to good things in life, and learn more about them. Trading CFDs requires a lot of analysis and time. If you do not have one, it is better to focus on fewer markets.
Risks with CFD trading.
Although CFD trading has many benefits, it is vital to read before making your first purchases. As previously mentioned, you should first see which stockbroker or CFD trader best suits your needs. The broker should have a good reputation from his clients and good experience.
Another thing you should be aware of is what requirements you agree to when signing the agreement. If a CFD increases or decreases in value, it does so multiple times. This means you have the option of going minus. This is a risk you must keep in mind. You can lose more than you have invested in your CFD. The leverage effect that allows you to enjoy a higher return works in both directions. This may mean that a possible loss exceeds the amount you initially invested.
The risks you may encounter also vary depending on how active you are in CFD trading. Some risks affect those who have just started and want to test because they are inexperienced. Some risks affect those who trade the contracts daily due to their confidence. Those who trade daily can buy and sell around 250 contracts in one day. With so much action also comes faith and less patience. It is better to take a step back and analyze your decisions. Then you can see what results you have so that you know better how to act in the future. The market should analyze before starting to trade. If you do not have time for this, trading in CFDs can be very risky.
Based on the tips listed, it is clear that trading CFDs is simply about experience and insight. It takes time to learn to trade and how to do good analysis. It is good to give it some time to learn how to avoid the risks in CFD trading.
What is CFD trading?
CFD trading is something that has become very popular in recent years. Many new players and individuals choose to enter CFD trading for fun. Some also do it for the huge potential profit one can make with CFD trading. For many people, CFD trading is much better suited than trading stocks, for example. Those who have the time and patience or interest can make big profits with CFDs. Interest in trade is only growing and growing. If CFD trading is something for you, it is enough to test with a small investment first. Then do it in a market that you consider safe. Many successful traders are inspired by and take advice from, so why not start today?
The following options are available if you want to try CFD trading.
- Trade-in stocks, commodities, currencies, interest rates and indices worldwide
- Easy to trade in an asset that you think will go up or down in price
- 100% exposure to an asset, without having to own it physically
- Lever. With smaller capital investment, you can achieve a higher return.
When investing, it is imperative to protect your capital. Something that many people use is a relatively well-known 2% rule. It means that you should not risk more than 2% of your capital. If you have SEK 100,000 in your account, you should not risk more than SEK 2,000 per trade opportunity. Money management is an integral part of trading. Not mastering this is a quick way to ruin an empty account. I personally usually risk between 0.5-0.7% per trade depending on system, market and volatility.
What CFD instruments can you trade?
CFDs are very versatile and can be used to trade virtually any financial instrument. As a CFD trading specialist, AvaTrade offers a wide range of assets:
Currencies-More than 60 currency pairs (read about currency trading in our education section)
Index-Trade stock indices from around the world, including S & P500, DJ30 and OMX30
Commodities-Gold trading, oil trading & other energy resources, metals and agricultural products
Equities-Trading shares in large global companies and all the major IPOs
ETFs (exchange-traded funds)-Trading asset baskets delimited by region or industry
Bonds-Trade US, European or Japanese bonds and government securities