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Similar to options and futures, CFDs are derivative products: a contract, or agreement, between two parties to exchange the difference between the opening and closing price of a position, based on underlying price movement. It is important to understand that by trading CFD products, ownership of the underlying asset is not an option.
The CFD market delivers access to global markets, offering a broad range of tradeable asset classes, such as foreign exchange (Forex – think currency pairs), commodities, equity indexes (S&P 500 for example), cryptocurrencies (Bitcoin and Ethereum) and individual shares.
Online trading accounts also enable traders to effortlessly speculate on rising and falling markets. In order to short sell stocks through traditional share dealing, however, the action involves borrowing shares from your broker, selling them on the open market with the intention of buying the shares back at a lower price. Once the trade is liquidated, the borrowed shares are returned.
CFDs are leveraged products that mirror price movement of an underlying asset, which, in this case, are share prices.
Conventional share dealing involves taking ownership of the underlying shares in a company. Although some hold physical share certificates, many investors hold stocks in street name: shares registered in the brokerage account’s name. With stock CFDs, as highlighted above, investors bypass ownership.
Traditional route (cash)
To own shares, the trader must pay the full purchase price upfront. As an example, assume Facebook (FB) trades at $300.00 a share (this can be any stock, such as Apple [AAPL] or Microsoft [MSFT]). To physically own ten shares, the interested party must pay $3,000. This is the full purchase price, or notional value.
CFD trade (leveraged)
To invest in the same market through a CFD contract, the trader sidesteps the full purchase cost and pays a deposit, known as margin. This may be 20 percent of the notional value, $600.00. Generally, an individual CFD position is equivalent to one share.
To access leverage, CFD traders must open a margin account and deposit sufficient equity to cover margin requirements (initial margin and maintenance margin).
Stock CFD Trading: A Professional Approach
A number of factors are required to form a professional approach when trading stock CFDs, which should be detailed in a comprehensive trading plan.
One of those factors is market selection.
In the stock market, two common methods are employed: top-down and bottom-up analysis.
Top-down analysis initially involves macro level analysis: the country’s geopolitical stance and Gross Domestic Product (GDP), for example. Following this, sectors are identified. Sectors represent a large segment of the economy. According to the Global Industry Classification Standard (GICS), there are eleven key sectors, including energy, consumer discretionary and consumer staples. After this, specific industries are determined. For example, the consumer discretionary sector has industry groups in automobiles and components as well as retailing and consumer services. Following this decision, specific stocks are then selected from within the groups. This method is common in fundamental analysis.
Bottom-up analysis, as the name implies, begins by selecting stocks of interest based on price behaviour, earnings and cash flow. The method is more technically oriented as it combines relative strength analysis. Relative strength informs market participants which stocks are outperforming the market. The most common method of relative strength analysis is the ratio method, which involves dividing two instruments, industries or sectors.
Technical Analysis Vs. Fundamental Analysis
To help highlight trading opportunities, technical and fundamental analysis are common methods of analysing the stock market, or any financial market. Fundamental analysis helps explain reasons behind a market’s movement, while technical analysis typically informs traders of the most optimal price level in which to initiate a position.
Among retail investor accounts, the more popular of the two strategies is technical analysis, an approach incorporating trend studies, price action methods and technical indicators, such as the relative strength index (RSI) – not to be confused with relative strength analysis briefly touched on above.
Those new to trading may find use in FP Market’s Traders Hub, offering a number of educational articles, together with daily technical and fundamental analysis from industry experts.
Professional CFD traders, whether that be scalpers, day traders (day trading) or long-term position traders, not only understand their analysis, they also recognise the need for a thorough trading plan.
Among other things, a trading plan contains trading strategies, risk-management rules and a money-management approach, trading goals and a trading journal. It is also no secret that trading psychology plays a vital role in a trader’s success. Demo accounts (trading platforms that facilitate simulated trading) are also vital tools, allowing traders the freedom to experiment with different financial instruments and CFD providers.
Further to this, professional traders understand how to buy and sell share CFDs: the operation behind their trading account.
Factors such as the bid/ask spread, what a long position or a short position means as well as the correct use of a stop-loss order are crucial to understand. In addition, professional traders are aware of their CFD broker’s regulatory stance: are they regulated and in which country (Australia, London [think of regulators such as the Financial Conduct Authority FCA] and Japan, for example)? Other elements professional traders are mindful of is how their CFD broker processes orders, meaning are they a market maker, a direct market access (DMA) broker or an ECN broker?
Trading is a never-ending learning process. Good traders embrace this fact and are always striving to develop and grow in the financial markets.
Disclaimer: The information contained in this material is intended for general advice only. It does not take into account your investment objectives, financial situation or particular needs. FP Markets has made every effort to ensure the accuracy of the information as at the date of publication. FP Markets does not give any warranty or representation as to the material. Examples included in this material are for illustrative purposes only. To the extent permitted by law, FP Markets and its employees shall not be liable for any loss or damage arising in any way (including by way of negligence) from or in connection with any information provided in or omitted from this material. Features of the FP Markets products including applicable fees and charges are outlined in the Product Disclosure Statements available from FP Markets website, www.fpmarkets.com and should be considered before deciding to deal in those products. Derivatives are complex instruments can be high risk; losses can exceed your initial payment. FP Markets recommends that you seek independent advice. First Prudential Markets Pty Ltd trading as FP Markets ABN 16 112 600 281, Australian Financial Services License Number 286354.