CFDs or Contracts for Difference belong to the derivatives asset class, allowing traders to speculate on financial markets like forex, indices, commodities and cryptocurrencies, without having to own the underlying asset. The contract pays the difference in the settlement price, between the open and closing period. CFD trading strategies offer flexible trading options for market players. Some of the other advantages of trading CFDs are:
- Access to the global financial markets
- No need to buy the underlying asset at full face value
- Flexibility to trade in both falling and rising markets
- Leveraged trading available
- No set expiry date for contracts
- Opportunity to hedge risk exposure
However, leveraged CFDs can be risky. Since leveraged trading increases exposure to the market, it magnifies both profit and loss potential, based on market direction. If you are a beginner, consider having a proper plan before investing in any type of trading, including CFDs. Here are some essential tips when developing strategies for trading CFDs.
Learn All About This Derivatives Product
Derivatives are financial products known to promote market efficiency and provide access to assets that would otherwise be beyond your reach. However, they carry volatility risks as well. Before you start trading CFDs, understand how the market works. Consider being well versed in common terms like:
- Going long or going short
- Maintenance margin/Variation margin
- Lot size
- Rolling contract
- Stop-loss and take profit
- Settlement date
Moreover, a detailed understanding of the underlying market, whether forex or equities or commodities, is always useful. For instance, the price of forex CFDs largely depends on the supply and demand of the underlying currency pair, whereas spot forex trading relies on fundamental factors that impact currency values. Contract sizes for oil CFDs differ from forex CFDs. Commodity CFDs like oil allow traders to speculate on the price of oil futures contracts. Forex CFDs allow traders to speculate on spot forex pair rates.
Consider All Factors to Make a Trading Plan
Your trading goals, risk appetite, trading capital, financial knowledge and timeframe are some of the important factors to consider before developing a plan. It is wise to acknowledge weaknesses too. Even if you have experience in trading other markets, CFDs may need quite a different approach.
Focus on Capital Preservation
At first, CFD trading strategies need to focus on capital preservation. Every dollar you spend is precious, so best to keep losses small by avoiding risky strategies. When you are just starting out, focus on learning and testing various strategies on a demo account first. As you become experienced, you could try more ambitious trading strategies.
Choose the Right Leverage
Leverage could allow you to capture greater gains from small price movements of the underlying asset. However, in the event that the market moves in the opposite direction, it can magnify losses too. So, choose the leverage ratio wisely. For beginners, a conservative risk profile could be more appropriate. This means choosing ratios like 50:1 or 100:1. Consider this especially for indices and shares, which have lower liquidity than the forex market and higher volatility.
Consider Asset Correlations
CFDs can help hedge risk exposure. But for that, you need to consider the factor of asset correlation. Correlation is the measure of how two assets move in tandem or against each other. Many traders trade two different CFDs in one industry, one long and one short. Some might consider two markets that show negative correlation, such as the US Dollar and crude oil.
Pair trading can allow you to capitalise on the divergence between the two underlying assets. Depending on the market trend, you will need to choose a weak and a strong asset. You can assume a long position for the weaker asset and a short position for the stronger one. The overall market direction usually does not affect the overall results. It is the difference between the two asset prices that counts.
Choose a Regulated Broker
It goes without saying that trading should be done with full peace of mind. A regulated broker will ensure safety of your funds and also provide guidance and educational resources for trading. Look for a broker offering these kinds of features:
- State-of-the-art trading platforms
- ECN pricing
- Range of financial instruments
- License from a coveted financial regulatory body, like the ASIC, FCA or ESMA
- Multiple trading tools
- Reputed liquidity providers
- Knowledge resources
Finally, practice your strategies on a demo trading account. With patience and discipline, your well thought out CFD trading strategies can indeed become fruitful ones.