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Many traders open a CFD trading account without knowing what CFDs are, or how to use them to increase their trading performance. Unfortunately, this often leads to disastrous situations. They lose most of their trading capital, undermining their confidence.
So what can you do to avoid that?
It might sound obvious, but the first thing to do is to know what you are dealing with before using real money on any financial product. CFDs are easier to understand than you might think, and we will explain everything there is to know in this article:
- What are they
- What are their risks
- The advantages of trading them,
- How to use them in your trading to enhance your performance, and
- Which kind of trading style fits best this financial product.
What are CFDs?
CFD stands for Contract For Difference. It’s a contract between you and your broker to exchange the difference in the value of your position between the time of its opening and its closing. While using CFDs you can take advantage of the fluctuation in the price of many instruments.
The top CFD markets are:
- Shares such as Facebook, Total, or Telefonica,
- Indices like the Dow Jones, the Dax30, or the Nikkei,
- Currency pairs like the EUR/USD,
- Commodities like Oil,
- Crypto-currencies such as Bitcoin, Litecoin, or Ethereum,
- Options on shares, indices, commodities, among others,
- And interest rates such as the Fed Funds,
It’s important to understand that when using CFDs you do not own the underlying asset. Let’s have a look at an example.
Looking at this chart, you might want to invest in Apple shares, as you think that their value will keep rising.
First, because prices bounced back from the lower band of the Bollinger band indicator after a steep fall. This indicator helps traders understand how volatile an asset is. When prices are very close to/outside the upper or the lower bands, then prices are in an extreme situation. It’s common to think that they would then return to an average price.
Secondly, the last bearish candle that you can see is a bullish candlestick pattern called the hammer. This pattern is one candle formed by a small body, a long lower wick and almost no upper wick. It often appears at the end of a bearish movement to signal that prices are about to change direction.
And finally, because the RSI indicator exited its oversold zone with a bullish divergence, this suggests that prices might reverse. The Relative Strength Index (RSI) is used to spot oversold and overbought situations, where prices might be about to reverse. In addition, the RSI is forming an inverse head-and-shoulder pattern. This bullish pattern suggests that the indicator is about to reverse and evolve upwards as the neckline has been broken (in green).
A divergence appears when the price “disagrees with” the indicator, so then they evolve in opposite directions. A bullish divergence occurs when the indicator forms higher lows, while prices forms lower lows. A divergence doesn’t automatically trigger a reversal. However, it shows that prices are losing momentum and that the trend might be about to change.
So, after this analysis, you decide to buy CFDs on Apple. It means that you will only profit from the difference between the opening price and the closing price of Apple’s shares without really purchasing Apple.
1st CFD Characteristic: You Do Not Own The Underlying Asset
Trading a CFD is done just like any other financial product. You will always have 2 prices: the ask price (buying price) and the bid price (selling price).
Why is The Buying And Selling Prices Different?
With this example on the EUR/USD from the MetaTrader platform, you can see that you have 2 prices to invest in the EUR/USD currency pair. The Bid and Ask is a 2-way quotation that provides you with the best available rate at which you can buy (ask – in blue), or sell (bid – in red) an asset.
The difference between both prices is called the “spread” and is usually how your broker makes money. In addition to the spread, your broker can apply a commission. It can be a percentage of your position depending on its size, or a fixed amount. However, this commission is never applied to the currency market, also called the Forex market.
At this point, you might think: “CFD trading looks like trading any other financial products…” However, it's not correct.
CFD trading is based on margin trading and leverage, which is not available with traditional financial products.
How Do Margin And Leverage Affect Tour Trading?
CFDs are margin and leveraged products. It means that to open a position you only need a small deposit and not the total value of your position. For example, let’s say that your Forex broker is asking for 1% of the total value of 1 lot. Remember that 1 lot is the standard size in the FX market, which represent 100,000 units of a currency.
2nd CFD Characteristic = You Only Need To Put Aside A Small Portion Of Your Trading Positions To Open Them And Keep Them Open.
It’s called margin trading. If you want to invest in 1 EUR/USD lot, then you will only have to put aside the 1% that your broker requires to open this position, which is called the margin. For 1 lot on the EUR/USD, then you need to put aside 1% of 100,000, which is USD 1,000 as a collateral.
Let's see another example. Your broker is asking for a margin percentage of 5% for French shares, and you want to buy BNP Paribas. The share price is currently at EUR 63, and you want to buy 100 shares.
The standard margin to open a position on BNP Paribas would be EUR 315 (100*63*5%). If you had bought BNP Paribas’ shares through a traditional broker, you would have to pay to full amount upfront to own them – meaning EUR 6,300 (100*63).
Using CFDs means that you can borrow funds from your broker to trade financial assets, which will be the collateral for the borrowed funds, in addition to the margin. This process means that you can invest more money than you have in your account. This is also called leveraged trading.
3rd CFD Characteristic = Leverage Allows You To Have A Greater Market Exposure Than Your Trading Capital Would Normally Allow
To know the leverage you are using, you can compute it with the margin and the position size. Using the 1st example, the leverage would be 100:1, or 100,000/1,000. Regarding the BNP Paribas’ example, you are trading with 20x leverage, or 6,300/315.
So, the lower the margin requirement, the less capital outlay for you, and the greater your potential returns.
Trading is now available to small investors, which only need to put a few thousand on an account to manage hundreds of thousands.
However, this isn’t without risks…
CFDs Main Risks
Leverage, while a great tool in the hands of those who know what to do with it, also means that every movement on the underlying asset is amplified.
Leverage magnifies the price movements, which can be dangerous. When the asset goes in the opposite direction of your scenario, you lose more money than with traditional investment methods. It’s also possible to lose more money than you possess in your account. Never forget that leverage is a double-edged sword, as it can wipe out your account.
CFDs are derivative products exchanged over-the-counter (OTC) meaning that there are no clearinghouses to protect investors against the counterparty risk.
This risk is associated with the fact that the counterparty of your contract might not be solvent anymore. In this case, it won’t be able to meet its financial obligations.
Lack of Transparency
Before choosing your CFD broker, it’s important to understand the differences between the different types of CFD models used by providers to structure and price their CFDs. The 2 main types are DMA (Direct Market Access) and Market-Marker.
With the DMA model, you access the order book on the exchange, and your CFD order is directly placed in the market. Using Market Maker brokers, on the other hand, means that you are trading with an in-house trader. Market Makers only act like middlemen, mirroring the price of the assets found in the physical market. In this case, prices and liquidity might differ from the exchange, and the price transparency isn’t total.
While leverage can have a negative impact on your account, it also allows you to make more and faster profits when the asset goes in your direction. It also allows you to start trading with a small amount.
With a CFD account, you can trade different asset classes, so you have access to the global markets in one trading platform. You can create a diversified portfolio and use inter-market analysis to invest in positions with the biggest profitable trading opportunities.
Inter-market analysis is the study of the relationships between different asset classes. In order to detect turning and reversal points, investors use correlations between the markets to understand how they influence one another.
Many CFD Trading Strategies
With CFDs, an investor can go long or short sell an asset depending on his/her scenario. Short selling means that you will sell an asset, and buy it later on at a lower price, because you think that its value will decrease.
With CFDs, you could have taken advantage of the fall in the Dow Jones that you see on the following chart. There are several technical signals that indicate where to enter the market with short positions.
The 1st sign appears after a bearish gap, as the index forms another bearish candle with the RSI exiting its oversold area. It shows that prices are weakening and that they might be on the reverse.
The 2nd sign is a confirmation of the downward movement, as the Dow Jones crossed below the moving average a few days later. In addition, it does this with a long red candle without any wicks, which means that the movement is strong and there is no volatility. This candlestick pattern is called a marubozu.