If you are reading this, you are probably motivated to start trading. That’s a great idea as the financial market is fully open for you online. But what should you do if you need to start trading with a small entry capital? CFDs might be the best option to start with. However, their technical and abstract concepts require time to be learned.
Before you start testing trading CFD strategies, it would be wise to study this beginner’s guide by investous.com to realize how things work.
What Are the CFDs?
Similar to options, futures, and swaps, Contracts for Differences (CFDs) are financial derivatives. It means that you don’t need to own them to trade an asset. It’s a contract between two parties who intend to speculate on the underlying asset price movement.
Based on the agreement, the participants can exchange the difference that appears between the opening and closing of the contract. Underlying assets can include a variety of items, including shares, commodities, cryptocurrencies, indices, etc.
How Does CFD Trading Work?
Given that you don’t need to own a currency or stock, you have to make an informed forecast on the rise or decline of the asset price. You have two options here:
- Going short – expecting a decline, you can issue a “sell order.” When the price drops to a certain level, you can close this position with a “buy order.”
- Going long – in case you predict the rise and issue a “buy order,” you can decide to sell the asset when the rise occurs and earn a profit on the difference.
The benefit of this concept is that you don’t have to borrow any instruments to sell it. If your prediction comes true on the agreed date, you will receive income equal to the difference from the other party. Otherwise, you pay the difference to the seller. Fair enough!
You need the knowledge of margins in order to open a leveraged trading position and use it successfully. The initial margin is a deposit amount that’s equal to the difference between the amount you borrow from a leverage provider and the full value of the position you open. The leverage will be used to cover the losses that may occur.
If the losses reach the initial margin amount, you will be asked to deposit a maintenance margin. It’s called a margin call. It’s important to keep an eye on the CFD margin table of your broker, as the leverage can both increase the gains and expand the losses. That’s why careful risk management is necessary.
Main Advantages & Risks
CFDs are good for portfolio diversification as they let you trade a variety of assets from a single platform. Unlike other derivatives, they don’t have contract sizes and fixed expiry dates. Still, you may need to pay interest fees and holding costs for these conveniences.
Using leverage, you can open bigger positions without a large capital, and you can gain profits from both positive and negative market movements. There’s no limit to the price difference. However, the losses from the leveraged position can be magnified as well. CFDs are quite risky, still manageable. The market experience is advisable if you don’t want to end up covering the losses.
Is It Yours?
CFD trading is a good opportunity to enter the market or expand your profile towards a new vector. Evaluate the risks and benefits, and do your best to understand whether CFDs match the type of your trading personality. There’s no place for greed and over-confidence. Remember that your future success is driven by knowledge, logic, cold calculations, and thorough strategies.
Interesting Related Article: “Trading Shares versus Trading CFDs“