The use of leverage, access to global markets, and the ability to trade long (buy) and short (sell falling markets), positions the CFD market as a top contender across the financial space.
Contract for differences, or CFDs, are leveraged trading products that mirror the price of underlying markets. CFDs represent an agreement, or contract, between buyers and sellers to exchange the difference between the opening and closing price.
CFDs are there to speculate on the future direction of a market’s price movements, without taking ownership of the underlying asset. CFD hedging is also a popular strategy to offset potential losses. Most CFD trades also have no fixed expiration date and are settled in cash.
According to research, CFDs were invented in the early 1990s by Smith New Court, a derivative brokerage firm based in London, developed to cost-effectively hedge exposure using leverage. This gave birth to rapid expansion in the CFD market. In Australia, CFDs were not launched until 2002, when IG Markets opened their doors, followed closely by CMC Markets.
In addition to this, traders in the UK are able to avoid UK stamp duty as CFDs base positions on agreements.
The first step for any professional trader is market selection. A major benefit of trading CFDs is having access to several markets. FP Markets offers traders instant exposure to a number of key CFD instruments, including foreign exchange (think the Forex market – currency pairs), Indices (index CFDs), Commodities (commodity CFDs include crude oil and gold), Stocks (Apple, for example) and Cryptocurrencies (think bitcoin and ethereum).
Market selection is key in any trading strategy. Professional CFD traders, however, seldom engage with all financial markets. They tend to select one or two key instruments that suit their trading approach, Forex trading, and a stock index, as an example.
Determining if a market is positioned favourably is typically founded on the back of two common trading approaches: fundamental and technical analysis. Fundamental analysis tends to answer the question of why a trade is likely to move in the desired direction, whereas technical analysis generally answers the question as to when a trade should be executed. New traders working with a demo account may find FP Market’s Traders Hub helpful, offering daily technical and fundamental analysis from industry experts.
Professional CFD traders not only understand their analysis but also recognise the operation behind buying and selling any financial instrument. In brief, the bid is the value traders can sell, while the ask (sometimes referred to as the offer) is the buy price. The difference between the two is known as the bid/ask spread. CFD brokers (or CFD providers) operating as a market maker, broker routing orders through a dealing desk, essentially make the market. They determine the spread in this case and ultimately earn revenue through this mechanism – which can be fixed (though are subject to change).
To start trading CFDs a margin account is necessary.
Initial margin is used as collateral to open and maintain a leveraged position. In other words, you place a deposit upfront. Margin requirements vary from broker to broker.
When most think about trading, it’s believed large sums of capital are needed in order to open a trading account. This may be the case for some investments; CFDs, however, offer more of a convenient path due to the use of leverage. Leverage, or sometimes referred to as ‘gearing’, essentially increases your buying power and risk of loss. However, leverage is not a ‘loan’ from your broker, despite many claiming so as CFDs work in agreements. The CFD contract size can be found in the ‘contract specification’ tab within Market Watch located in the MetaTrader 4 (or 5) trading platform.
Position sizing is important. It is one of the key components of successful trading. Professional traders understand once the psychology of trading is in check, as well as having a sound strategy for selecting entry and exit points, the final factor is position sizing (part of risk management).
Professional CFD traders appreciate the significance of trade management. A winning trade can swiftly turn into a loser if managed incorrectly.
Some traders opt for a simple ‘set and forget’ strategy. This works well for those who prefer a ‘hands-off’ approach. As its name implies, traders configure the trading parameters prior to trade execution. This tends to help lessen the emotional impact of trading.
Other traders opt for more of a manual approach, with some preferring to average in and out of positions based on price action. There’s also the aspect of when to reduce risk to breakeven and whether using manual trailing stop-loss orders is optimal.
The idea of trade management is to get the most out of each trade while adopting strict risk and money management rules.
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