Becoming a CFD Trader
Introduction to CFD Trading
A Contract for Difference (CFD) is a contract between two parties(broker and trader) where the trader speculates on which direction an underlying or base asset will have moved at the exact time of the contract finishing. Upon agreement end the trader will exchange the difference with the broker according to the outcome value. If the trader wants to speculate that the value will rise they would go long (buy) or if they believe that the value would drop they will go short (sell). Should the trader opt to go long (buy) on CFDs for 10,000 shares @ 10p a share and they increase in value to 15p a share, the profit for the trader would be 5p x 10000 = £500 + Dep.
The Theory Behind CFD Trading
If the trader goes long (buys), they do so on the basis that the underlying asset value will increase so that the compulsory purchase or buy-back by the broker at the end will be at a larger value than which the trader paid. Therein lies the profit. The difference between opening value and closing value is exchanged between trader and broker where the broker owes the trader if the trader speculates correctly, or the other way around if their prediction fails.
The Beauty and the Beast of Leverage
CFD trading has several benefits including the fact that it is a leveraged product. What this means is that, unlike traditional share dealing, the trader is not required to provide all of the funds for the entire trade in advance. Only a small margin or deposit is needed to secure a CFD trade and is usually 5% of the value of the underlying asset value. So, if a trader wishes to trade 10,000 shares at 3p per share the margin would be 10,000 x 3p x 5% = £15, when the value of the trade is actually £300. The earlier example offering a £500 profit would require a £1000 initial outlay if it were a traditional share dealing transaction, plus the additional commissions and taxes on the profit. The CFD equivalent value trade would only require a margin of £50. However, if the trade did not work in the favour of the trader by dropping 5p per share then the loss incurred would be £500 + £50.
What Makes CFD Trading So Attractive
The appeal of CFDs includes the potential for traders to profit from markets whether they are rising or falling. CFDs can be traded 24 hours a day and offer investors the opportunity to trade in thousands of markets globally including commodities, indices, currencies and interest rates. CFD trading in the UK currently attracts zero percent Stamp Duty and Tax although tax laws are subject to change at anytime, so staying up to date with all of the latest laws and regulations is essential.
Hedging Your Portfolio
Another reason many traders are attracted to CFDs is that they can be used to offset losses in your main portfolio by going short with CFDs on stocks or shares in your portfolio that you believe will lose some value. If executed correctly, any losses suffered from your portfolio would be counterbalanced by the gains in your CFD account. Having said that, going short with CFDs for an asset in your portfolio that actually rises in value could mean that the losses incurred through the CFD could negate any profits on your affected asset. Hedging does take skill and experience so not to be tried if you are unsure about what you are doing.
The Next Steps to CFD Trading
The vast majority of CFD trading is internet based which makes it that much easier to make trades quickly. Because of this one has to be very careful not to expose oneself to the real markets before being ready. First, you will need to find an established online broker by researching companies like CMC Markets to see what others think of them. The top online brokers offer demo accounts where you can use virtual money as you learn how to trade. Take full advantage of demo accounts as you will need a lot of training and practice before you go live. The day that you are ready to go live, only an initial deposit is required to begin trading. But do not do this alone and be sure to find a reputable broker offering a wealth of training materials to guide you through the initial stages.