CFD Trading for Dummies

What is CFD Trading?

A CFD (Contract for Difference) is an agreement between a trader and a broker where a trader speculates on the value movement of an underlying asset. From the outset of the contract the trader agrees to buy (go long) or sell (go short) following a specific time frame. For example, if the trader decides to go short by agreeing to sell an underlying asset in a week (or any duration) from the day the contract starts then the trader has speculated that the value of the underlying asset will have dropped by the end of the contractual period. If they are correct then they will be paid for each price drop in value and get their original deposit back. There are no guarantees in any type of trading so prospective traders are advised to do as much research as possible and avail themselves of all training opportunities available.

CFD Trading for Dummies

The Benefits of CFD Trading

The benefits of CFD trading include the fact that they are leveraged products. This means that the trader only needs to deposit a small percentage (or margin) of the full value of the trade but takes full benefit of the trade should it go their way. For example, if a trader paid an initial margin requirement of £50 as 5% of 1000 CDFs @ 100p each and they went short; a resulting drop leading to the contract closing with a value of 80p would mean the trader has been successful in their speculation. Consequently, the drop in value is 20p multiplied by 1000 = £200 profit. Now, because of leverage the trader did not actually have to put down the full value of the trade which would have been £1000. The fact that CFDs are derivative products and are only based on value changes in the underlying asset means that traders can benefit whether the markets are rising or falling. One just has to correctly predict which way the markets will move.

Use CFDs to Hedge Your Portfolio with No Stamp Duty

A popular way to use CFDs is to offset losses suffered from a main portfolio. A typical scenario would be where a trader has shares in a company worth £1000 and believes they may suffer some losses. They then go short on the same stocks using a CFD trade of the same value so that if they lose anything with the main holding it is offset by the CFDs.

Another benefit of CFD trading is that it is exempt of stamp duty in the UK which equates to a saving of 0.5% on every trade. Only Irish stock attracts a 1% charge which is refunded if traded out within a period of 30 days.

What are the Risks of CFD Trading

The risks involved in CFD trading are related to the benefits in that the same leverage enabling traders to leverage returns, can also mean losses greater than deposits if predictions do not materialise. In the event that a trader’s losses pass a certain percentage of their held deposit, all open positions under their account would be immediately closed and settled at the then current rate to minimise potential loss for the broker. This is known as margin close out. Be sure to always seek reputable advice if you are unsure about the risks involved in any type of trading.

How do I Start Trading

Most CFD trading is carried out online so finding a reputable online broker is an essential step in beginning the process to becoming a fully fledged trader. Never stop reading through the more respected online financial news channels for tips and free training material. There are several reputable online brokers, such as CMC Markets and similar sized firms, who offer demo accounts to practice using their dashboards while you are training and before putting in any real money. Always research any prospective trading type thoroughly before committing to a live account and never invest more than you can afford to lose. Develop a strategy over time but more importantly, have a cut off point in terms of how much you intend to invest and keep to it.