In most markets, you will find two forms of trading; spot and derivative trading. Spot stands for buying and selling the actual asset on a trading platform, while derivatives involve trading financial instruments attached to the actual asset. These instruments exist in the form of contract for difference (CFDs) and involve speculating on financial markets that don’t require the buying and selling of the underlying asset. CFDs enable traders to speculate on financial markets such as shares, forex, indices, commodities, and crypto without having to take ownership of the underlying; therefore, when you trade CFD, you agree to exchange the difference in the price of an asset from the point at which the contract is opened to the when it is closed. A great advantage of CFD trading is you can speculate on price movements in either direction, unlike spot markets using leverage.
Leverage in CFD trading boosts your capital, thus increasing your potential earnings. You gain exposure to a large position without committing the full cost at the outset. For example, if you wanted to open a position equivalent to 500 Tesla shares with a standard account, you would have to pay the full cost of the shares upfront. On the other hand, with a contract for difference, you might have to put up 5% of the cost. Even though leverage enables you to spread your capital further, it is important to remember that your profit or loss will be calculated on the full size of your position. Using the example above, it would be the difference in the price of 500 Tesla shares from when you opened the trade to when you closed it. That means profits and losses can be hugely magnified compared to your outlay, and your losses can exceed deposits. For this reason, you need to pay attention to the leverage ratio you choose to use and make sure you are trading within your means.
Understanding Margin
At times, leverage trading is referred to as “margin trading” since the funds required to open and maintain a position “the margin” represents a fraction of the total size. When trading CFDs, there are two types of margins. A deposit margin is required to open a position. In contrast, a maintenance margin may be required if your trade gets close to incurring losses that the deposit margin and any additional funds in your account will not cover. When this happens, you will get a margin call from your provider asking you to top up the funds in your account. If you do not add sufficient funds, the position may be closed, and any losses incurred will be realized.
Hedging With CFDs
Another good thing with CFDs is they can be used to hedge against losses in an existing portfolio. For example, suppose you believe some Tesla shares in your portfolio could suffer a short-term dip in value due to a disappointing earnings report. In that case, you can offset some of the potential loss by shorting the market by opening a CFD position. By hedging your risk this way, any drop in the value of Tesla shares in your portfolio is offset by a gain in your short CFD trade.
How To Make The Most Of CFDs
CFD trading is no joke, given the use of leverage. You can make a lot of money and lose all your capital if you are not careful. Therefore, you need to know how to properly manage risk. It all comes down to dedicating time to understanding how to trade by learning technical and fundamental analysis. You can use the free resources offered by various platforms and use Google and YouTube. You can also opt to buy a reputable course. Also, remember trading is like a sport. Just like athletes spend hours training to play for a few minutes, you need a lot of practice to perfect your strategies and gain the confidence you need to succeed. Consider backtesting using demo accounts, and when you get to the actual trading, use amounts you are comfortable with.
Source: Plato Data Intelligence: PlatoData.io
