Have you ever wondered what exactly is a CFD?
Investopedia describes a CFD as “a tradable contract between a client and a broker, who are exchanging the difference in the current value of a share, currency, commodity or index and its value at the contract’s end”.
CFDs are relatively new financial products that have become more and more appreciated by investors over the last decade. When you trade CFDs, you do not own the underlying asset – you are only paying or collecting the difference between the opening price and the closing price of the underlying asset.
It’s All About Leverage
This trendy instrument is a leveraged product that will allow you to use margin trading to increase your trading exposure. Margin trading means that every time you open a position, a fraction of this position will be put aside as collateral (the margin).
Consequently, you will be able to invest more money than what you currently have in your trading account. As a result of this leverage, market movements are amplified, regardless of whether it’s going up or down. This allows you to make more profits, but it also increases your potential losses.
For this reason, it’s essential for you to apply sound risk and money management rules to better protect your trading capital.
What Are The Best 3 CFD Trading Strategies?
1. News trading
Most of the time, when you use CFDs, you use an intra-day, scalping or day trading strategy. In this way, you do not have to pay any fees to keep your trading positions open overnight. These strategies require a lot of time, dedication and focus to follow the markets and try to outperform them. Intra-day and day trading strategies mean that you will open and close a position within the same trading session.
One of the strategies that work well with CFDs is “scalping”. Thanks to the higher flexibility and low transaction costs of CFDs, scalping is ideal for trading the news. With this strategy, you take advantage of small and quick profits within a few minutes or even seconds.
To be successful with news trading, it’s important that you follow a comprehensive economic and financial calendar, so then you will be aware of upcoming events or statistics that could affect the underlying asset you are trading. The calendars on Forex Factory or Investing.com are the most popular such calendars among traders.
How To Trade The News?
With this strategy, you can either invest before a statistics’ release or just after the release. The aim of the 1st option is to try to understand and anticipate traders’ reactions to the upcoming release. This can be very risky, as it’s hard to know whether the release will be above, below or meet the market’s expectations, or even how the market will react to such news (sometimes, bad news on the market is in fact treated as good news, and vice versa).
The second way to trade the news is to go with the flow, knowing that prices can easily and rapidly change direction. It’s then very important to use strict money management rules when news trading. You shouldn’t invest without stop-loss and take-profit orders, so then you can manage your risk.
If you are trading currency pairs, it’s important to follow any statistics that are important for central banks, as they are the main market mover in the FX market. Any statistics about growth, employment, consumer/business confidence or inflation can influence the growth outlook of a country, which will, in turn, affect the demand for its currency. Of course, central banks decisions usually trigger the highest volatility on the market.
2. Pair trading
Pair trading belongs to market-neutral strategies and is usually used with CFDs on stocks.
However, you can use it with 2 ETFs, currencies, commodities, etc. The main advantage is that pair trading can be used with high or low market volatility. The market’s direction is also not really important to this strategy.
Choose an Industry
This strategy works when you invest in 2 different CFDs that belong to the same industry with one long position and one short position. Correlation is an essential concept of this strategy. The correlation is a measure of the connection/relationship between 2 assets.
With this strategy, you are using 2 usually highly correlated assets that have started to become less and less correlated. Any changes in the correlation of 2 correlated assets should imply a return to “the pair’s mean trend”. This is exactly how you can make profits with this strategy.
How To Trade It?
Pair trading allows you to take advantage of divergences between the 2 underlying assets. You first need to choose a strong and weak asset depending on the trend. You will then open a long position on the weaker asset – the one that is underperforming, while you will go short on the stronger asset.
Let’s pick 2 stocks within the French banking sector – if we see that 2 banks (Google and Facebook) suddenly aren’t following the same trend, then you know that the correlation is weakening. You can take advantage of this to make profits with a pair trading strategy. To take advantage of this divergence, short the company that is going up and go long on one company that is going down.
Usually, the overall direction of the market doesn’t affect the result, as you will be winning with one position and losing with the other one. The profit is based on the relative movement of the 2 stocks, not the market’s direction. Therefore, you will win on the difference between the 2 assets’ price, not the direction of these 2 assets.
Hedging is often compared to insurance. For instance, if you have a car insurance policy against accidents, and if something bad happens to your car, the negative consequences won’t are reduced. In finance, hedging is often used to reduce or completely negate risks from other investment vehicles. Hedge funds, big banks, and many other investment firms all use hedging to protect their investments.
Let’s say that you have a diversified portfolio with Coca-Cola, Bayer, BMW and BNP Paribas. You think that the French banking sector is weakening. You open a short position on BNP Paribas to hedge against a short-term decrease in BNP Paribas’ stock price.
Of course, you still have BNP Paribas in your investment portfolio, as you have a medium/long-term investment horizon. Another way to use hedging will be to hedge your whole portfolio with CFDs on an index rather than on a single stock. With our previous example, you could short the French index, the CAC40, or the French banking sector index.
Take Advantage Of Price Volatility
Using CFDs to protect more traditional investments is a great way to take advantage of price volatility.
This is especially true for blue chips. This strategy can also be used to prepare you for higher volatility or uncertainty. Many factors can affect the market in the short-term, which will affect the liquidity and the overall market conditions. Central banks decisions, company earnings being released, natural disasters and geopolitical uncertainty are among the most influential events.
Selling your shares in order to buy them back again later at a lower price could be costly with a normal broker. In comparison, CFDs are cheap and more flexible when market participants become less predictable. Of course, hedging isn’t adapted to all trading environments, so you should first take into consideration trading conditions.
When building your trading strategy, it’s important to first work on determining your trading profile. Think about your financial knowledge, your trading capital, your time horizon, your risk aversion, your financial goals, etc. Once you’ve answered all of these questions, you will be able to fine-tune your trading decision process. Based on that, you will be able to create a trading plan to follow.
Learn From Your Trades
To help you be sure you respect your trading plan, you can write a trading journal. It will help you to make a note of all the trades you’ve opened and closed. You can then explain the reasons why you entered and exited the markets. In addition to this information, you will be able to analyze if you succeeded or failed to follow your trading plan and why. It’s important to be able to look back on your trading history to better prepare future trades.
CFDs are complex products that might not be suitable for every investor. Leverage used with CFDs often means that you can lose more than your initial trading capital. However, it doesn’t mean that it’s impossible to learn to be profitable with CFDs. There are many strategies you can use with CFDs, such as MACD, RSI, Moving Averages, Trend lines, etc.
Share your trading experience with us: leave a comment! Do you trade CFDs? Which strategy do you use? What were the biggest challenges for you while using this financial product?
The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.