Contract for difference trading is a great option for traders looking to speculate on the increasing and decreasing trends of global financial markets. If you are a beginner, you’ll need to learn some essentials before you get started.
Here we will provide you with a comprehensive guide including the basics, risks of CFD trading, and common mistakes that beginner traders make.
What are CFDs?
CFD is the widely-used acronym for a ‘Contract for Difference’. As the name suggests, it represents a contract (with a broker) that permits you to speculate on whether the price of an asset will fall or rise over a set period.
As a financial instrument, CFDs are popular in the retail trading area, especially for experienced traders in the day trading network. Many brokers offer CFDs, with popular trading platforms supplying a wide variety of markets, with shares, indices, forex, and commodities, of which stock CFDs are the most common.
Essential CFD Terms to Know
Before you get started with CFD trading, there are a few important concepts you should familiarise yourself with. Let’s take a look at some of the basics and important CFD terms you should know.
1. Margin
Margin is the preliminary investment placed when you open a position. It is usually expressed as a percentage for example, ‘the change required is 2% margin’. This is the amount of cash or collateral that you must have in your trading account to open the trade. For example, if you want to make a trade with a cost of $10,000 and the margin is 2%, then you will only need $200 (2% of $10,000) in your account.
2. Leverage
In simple terms, leverage refers to the use of borrowed capital (in this situation, from your broker) to increase the potential return on investment. You can think of it as a loan that allows you to get a larger return, while not having to pay the total price upfront.
In CFD trading, leverage is expressed as a ratio of the entire amount of the investment to the amount of the initial deposit, for example, 2:1, 10:1, or even 100:1. The initial deposit (margin), is a percentage of the investment which you need to offer in cash.
Let’s study an example. Suppose a broker gives a leverage ratio of 10:1. This means for every $1 of your own money, you could trade $10 worth of a certain asset. If you have $1,000 to invest, you could exchange $10,000 worth of an asset.
But how does this increase your return? Let’s say you’re trading a CFD on a stock, and the stock’s price increases by 5%. If you invested $1,000 without leverage, your profit would be $50. However, with the 10:1 leverage, you have been able to change $10,000 worth of the inventory. So, a 5% increase might result in earnings of $500.
3. Long vs. Short positions
In CFD trading you’re speculating on the future price movements of an asset, rather than buying the underlying asset. The words ‘long’ and ‘short’ refer to the position you’re taking, when speculating which direction you think the asset will go.
Going long means you expect the price to rise, so you are buying an asset and then selling it later at a higher price, for a profit. Conversely, ‘going short’ means you think the stock price will fall. This approach, also known as short-selling, involves selling the borrowed asset in the hope that the price decreases, and then buying back the asset at a lower price.
Risks of CFD Trading
1. High Leverage
As mentioned previously, while leverage can increase your profits, it also exposes traders to much more risk. Leverage can magnify your losses where traders can lose significantly more than their initial deposit.
2. Market Volatility
CFD markets are inherently volatile and unpredictable, with price movements moving quickly. Traders need to be prepared for market fluctuations and put in place risk management strategies to reduce potential losses. It’s crucial to note that CFDs immediately replicate the market volatility of the underlying asset they’re based on.
3. Risk of Margin
Unlike traditional markets, margin names are a feature of foreign exchange trading, not CFD trading. Margin trading entails borrowing a budget from the dealer to grow the size of a role. However, assume the market movements towards the dealer.
4. Counterparty Risk
CFD trading exposes investors to counterparty risks. A counterparty is the broker or CFD provider that is on the other end of the contract. As they also depend upon the economic balance of brokers to honor their role, if they for example become insolvent or default, you as an investor may face difficulties gaining access to your funds or executing trades.
5. Costs of CFD trading
Generally speaking, all prices will be shown on the contract of the asset. However, when you trade with a CFD broker there are some additional charges you should be aware of. Let’s take a look at what additional charges you might incur when trading CFDs.
6. Spread
The spread in simple terms is the difference between the buy price (the offer) and sell price (the bid) of an asset. The underlying market price of the asset will be between the two with the buy price always higher than the sell price. The thinner the spread, the fewer costs involved and generally the more favorable for the trader. If the price moves in your direction, exceeding the cost of spread then you will make a profit. If the price doesn’t move outside the range of the spread, then you will lose the trade.
7. Overnight expenses
Overnight financing is a fee that will be debited to hold a CFD trading position for more than one day. As CFDs are leveraged, you are borrowing money from the broker, and a small amount of interest is charged for the broker to hold a long (buying) position.
8. Market information charges
To view rate information for CFDs, traders will need to pay for the data through a market records subscription. However, not every CFD platform charges market information subscriptions.
How to Start Learning CFD Trading
When you’re starting, it’s important to understand the risks involved with CFD trading. This includes learning about the CFD providers available on the market and concepts like leverage and margin.
Here are some things to consider when starting with CFD trading:
- CFD broker: Look for a broker that offers good education material on CFDs, a user-friendly platform, and high-end support.
- Educational resources: You can get various online video courses for CFD trading. Your broker can also provide you with educational material for beginner traders.
- Practice: As a beginner, you may feel more comfortable practicing trading CFDs using a free demo account, before actually stepping into the market. Creating a demo account will allow you to strategies, analyze the movements in markets, and understand how the trading environment works.
- Make strategies: Now that you have learned the basics, start exploring trading strategies that suit your level of risk tolerance, for example, day trading, swing trading, etc.
Common Mistakes to Avoid While CFD Trading
There is a very high chance that as a beginner you can end up making some mistakes in CFD trading which can lead to huge losses. Let’s learn about them:
- Neglecting risk management: You should be careful and plan for risk management such as setting up stop-loss orders, reducing the size of trades, and learning about the risks associated with leverage. It can help you guard against potential losses.
- Emotional decisions: Avoid making decisions based on emotion. The feeling of fear, greed, or overconfidence can lead to false decisions and you may end up in a web of losses.
- Overtrading: Overtrading is the most common reason for the diminished focus and increasing transaction costs. Make sure to set limits on your trading volume.
- Overlooking market trends: As a beginner, it is essential to have a look at the economic news and market situation before trading. This will help you in making informed decisions.
- Loss chasing: Understand that losses are part of trading, whether you are a beginner or an experienced trader. Don’t chase the losses by making riskier trades to try and recoup profits. It will most likely lead to further losses.
- Ignoring the demo account: When you are a beginner, make sure to use the demo account before actually coming into the market. It will help you learn and understand the practical aspects of trading.
| Read more: Understanding Leverage In CFD Trading: A Beginner’s Guide
Conclusion
As a beginner, CFD trading can be challenging but not impossible. You will need to learn and understand the risks involved and whether trading this instrument is aligned with your risk profile and investment goals. Hopefully, this guide has been a helpful starting point.
