Is CFD Trading the Right Style of Trading For You?
Whats Does CFD Trading Involve?
CFD, or Cost for Differance, is a type of trading that involves predicting the behaviour of a base asset over a specific time frame. It’s a derivative trading that enables the trader to gain potential profit through speculation, allowing you to open a contract for difference in price of an asset based on the falling or rising prices of global financial products or markets such as currencies, indices, shares, commodities, and treasuries. What makes CFD trading popular is that it allows the trader to profit regardless of the direction of prices in the financial markets.
A CFD contract is normally between a trader and broker and derives its value from the difference between the value of the underlying asset when it was purchased (or sold) and when it is sold (or bought). A trader can either go long (buy) or go short (sell). If a trader decides to go short on a CFD for 50 shares to the value of $500 ($10 per share), they would be selling that pair with a view to buying them back after the CFD has ended in their favour. So, the trader has predicted that the price will drop by the end of the CFD contract period. If they’re correct and they drop to $8, the trader will be ‘in the money’ by $2 x 50 = $100. This is because they will virtually buy back the shares for the lower price which is when they realise the profit value. In short, with CFDs the profit is in the difference, as demonstrated in the above example. Whichever way the trader predicts, the profit or losses are proportional to the difference.
Leverage and Margin
A CFD is what is known as a derivative financial product because its value is tied to, or derived from, the value of a base asset but not in the actual ownership of that asset. It’s also a leveraged product meaning that only a small margin or deposit (often 5%) is required to place a trade for a much larger amount. Now, in the above example the trader did not have to actually pay the full value of the trade because it is a leveraged product. At 5% the trader would only have had to pay $25 to be exposed to a $500 trade. So they would have profited by $100 plus their original deposit of $25 which equates to $125 for a small £25 outlay. That is the beauty of leverage. But it’s important to take note that there is a potential downside to leverage, which we’ll look at below.
The Dangers of Margin Closeout
The same mechanism that can amplify the financial returns of a small investment can also amplify the losses. What this means is that if the above example went against the trader and the shares increased from $10 to $12, the trader would be at a loss of $2 x 50 = $100 + $25= $125. This example may not seem such an extreme loss until you increase the margin and trade value so that the 5% margin is actually $500. The trade would have been worth $10,000 and the loss $2500! If a trader’s account drops below a predetermined threshold they could face what’s called a ‘Margin Closeout’, where all of the open positions belonging to that account are arbitrarily closed at the current value, regardless of whether that puts them at a profit or a loss. This is done to safeguard the broker and the trader, since losses can be incurred rapidly particularly when there are multiple leveraged products being traded at the same time.
Can I Make Substantial Profits Trading CFDs?
It’s possible to make a decent and even substantial amount of money trading CFDs, but that doesn’t mean it’s for everyone, or that it will yield instant gratification. It’s important to fully understand how CFD trading works before attempting to start live trading to minimise your chances of a loss. Although you only need to invest a deposit, typically 5%, due to it being a leveraged product, as well as potential to make good profit, you can just as easily stand to lose more than your deposit if the trade moves against you. This is something that needs to be taken into careful consideration if thinking about whether CFD trading is right for you. Ask yourself if you have the patience and self control to be able to trade responsibly, and whether you can afford financially to withstand making a loss.
How Do I Know if CFD Trading Is Right For Me?
If you’ve come this far without being put of by the risks then CFD trading could well be right for you. As you’re only required to put forward a small deposit (as we’ve already discussed), this may appeal to those who don’t have don’t have a huge amount to start with. However, due to the high risk factor, I actually wouldn’t recommend CFD trading to someone in this position. CFD trading is best suited to a seasoned trader, who is confident in their abilities to make rational and well placed bets, with the foresight not to bet too high when there is an increased risk of loss. It is not for the flighty or impulsive trader. It would be sensible to use an existing source of savings or income to place bets, increasing the ‘pot’ as you profit, so that you’re never putting your stable income or assets in danger should you make a loss. CFD trading can certainly be a lucrative and rewarding, but it’s important to decipher whether or not you posses the traits to make it successful.
How to Start Trading CFDs Safely
The best way to approach CFD trading is rationally, and with a good understanding of both the positives and the pitfalls. Ensure that you understand the risks involved, and consider whether it’s worth seeking advice prior to starting from an independant financial advisor. Start by betting small, and never invest more than you can afford to lose. As well as this, finding the right online broker is very important when considering a career in CFD trading. Never be swayed by claims of virtually risk-free profit but look closer for a reputable and well established online broker with existing presence in the market place.
Filed under: Investing
Like this post? Subscribe to my RSS feed and get loads more!