Contracts for Difference (or CFDs) are financial derivatives
Contracts for Difference (or CFDs) are financial derivatives. What this means is that their price is derived from underlying financial assets such as individual equities, stock indices, currency pairs, commodities and bonds. This enables CFD traders to speculate on price movements in the asset without having to buy, or sell, the underlying entity.
In the early days CFDs were used by financial institutions for additional flexibility when trading individual stocks. CFDs allowed traders to take both long and short exposure on equities. This meant that financial institutions could sell CFDs on individual equities to cover an existing long position in the underlying stock. In this way they could engage in efficient, cost-effective hedging. They could cover themselves against a falling market without going through the bother and expense (including the capital gains implications) of selling and closing out their underlying position. In addition, CFDs are traded on margin which means positions can be highly leveraged. Consequently, they were the ideal financial instrument for the kind of institution that wanted a low-cost method of speculating and managing risk. But it wasn’t long before CFDs were made available to the retail market. Nowadays a CFD trading account gives you access to a large array of financial instruments including global equities, stock indices, currencies, commodities and other financial instruments.
With so much choice it sometimes can be hard to know where to start, particularly if you’re new to CFDs. So it’s understandable that some of the first questions people ask are: which is the best market to trade CFDs on and where can I make the most money? The simple answer is that the best market to trade on is the one you know most about. That in turn should give you the greatest opportunity to make money. After this you should consider other factors such as whether you’re better suited to day or longer-term trading or the costs of trading one market compared to another in terms of dealing spread and margin requirement.
It can be a bit overwhelming to log on to the platform for the first time and be confronted with loads of different markets with their prices constantly updating. Some novice traders are tempted to look at all that activity and jump straight in hoping to make what looks like a quick, easy profit. Please resist this temptation. Profitable trading requires careful planning and clear objectives. So the first thing to do is to simplify things. You can do this by picking a few markets with which you are most familiar. You may want to start off with a well-known stock index, such as the UK100, and a major currency pair such as the EURUSD. These are popular markets which have the advantage of tight dealing spreads and plenty of liquidity which in turn means they have low dealing costs. The less money you spend on the actual trade, the more you have to speculate with.
It’s also important to work out what sort of trading suits you best. Some people like short-term day trading. Typically, this means opening and closing trades within a day, or a single trading session. This avoids the extra costs together with the added uncertainty that comes with holding a position overnight. In fact, some day traders may run a position for only a few hours or even minutes. Day traders are constantly on the look-out for short-term opportunities. They tend to trade frequently and act when they consider a market to be oversold or overbought. Then they jump in to buy or sell in the hope of turning a quick profit. Day traders will typically have a tight risk/reward ratio. That is, they may be happy to risk £50 to make £50. Longer-term traders tend to look for bigger returns. They may look to make back three, five or more times their original stake. Due to the high frequency of trades and the narrow risk/reward ratio, disciplined risk management is extremely important with day trading. Day traders have to be prepared to use tight stops in order to avoid losing money if a market breaks out of its short-term trading range. They have to be extremely disciplined in choosing their entry and stop levels. They must be prepared to take a series of small losses and always have a profit target for every trade. Day trading won’t suit anyone who hasn’t got time to keep a close eye on the markets throughout the trading session.
Longer-term trading styles include swing trading. Unlike day trading, swing traders are happy to run their positions overnight, and can hold them for weeks if that is what their preferred technical indicators are telling them to do. In this way, they hope to capture bigger moves than those expected by day traders and this also means that they are generally prepared to take a larger risk in the hope of capturing a bigger percentage return. As with day traders, technical analysis is used to time entry and exit points. However, swing traders often also employ a range of indicators (usually chosen after extensive back-testing and trial and error) which can vary depending on the asset class they are trading. This is not to say that some swing traders don’t also use fundamental analysis, especially initially to assess when a stock, index or currency is under or overvalued. But technical indicators are vital - momentum, MACD, moving averages, Bollinger Bands, candlestick patterns and the Relative Strength Index are amongst the most popular indicators used. But Swing Traders tend to have their favourite combinations. The trick is to experiment, but also to understand fully what each indicator is trying to achieve. Also, avoid using any more than two or three indicators per financial instrument or things can become very muddled.
But whether you’re a short or longer-term CFD trader you should practice different strategies and closely follow market trends and patterns in order to identify high probability trades. This is where charting and technical analysis is so useful. Also, the more you concentrate on defining your strategy and exercising it on one market, the more likely you are to increase your chances of scoring profitable trades. So take your time to understand what you’re comfortable with and practice applying technical analysis to charts. The experience gained this way will boost your profit potential and then knowing which market to trade will be a no brainer.
Disclaimer: Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. This material has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. As a marketing communication it is not subject to any prohibition on dealing ahead of the dissemination of investment research, although Spread Co operates a conflict of interest policy to prevent the risk of material damage to our clients.