Many traders often wonder how to add diversity to their portfolio without compromising on the risk level. One of the many options on the market is CFD trading. In the following article, we will learn what is CFD, how to trade it wisely, what are its features and what it has to offer.
What is CFDs?
CFD trading, or contract for difference trading, allows you to trade on the price movements of an instrument without trading the instrument directly. This is what makes CFD trading so popular because you don't have to own the actual gold bars/oil barrels etc, which makes it a lot easier.
How do I trade CFDs?
CFD trading has the same terminology as normal forex trading does. Meaning that you use buys, sells etc. You pay commission on the trade, and the price and its currency will also replicate the underlying commodity.
You buy x number of CFDs and will earn the difference made times the amount of CFDs held- literally, a contract that you will make back the difference in money between the two prices. This is the spread.
What features does it offer?
CFD allows you to trade on margin, and also to go short and long (sell/buy) based on your belief of how the market will react. It can be a more tax efficient vehicle than traditional trading, and it makes a nice hedge for an existing, physical portfolio. Remember that holding fees and market data fees may be applicable to CFD trading transactions, alongside the commission due to your broker. A commission is usually charged both on the buying and the selling of the CFD, so it is essential you make a sensible selection for both.
Here are a few examples of how CFD works
Please note- all numbers depicted in this example are for learning purposes only and can change when trading.
While evaluating the markets, you decide that Walmart shares will rise this week. So you go long. Only, instead of buying Walmart shares directly, you buy 5000 CFDs. Perhaps CM trading was offering this at a sell/buy price of 565.5c/566.5c. Your agreed transaction commission is 0.1%
There are two possible scenarios:
The winning scenario - In a winning trade, share prices do indeed rise, and you cash in your gain buy closing the CFD trade. At this point, sell/buy prices are 570/571. There will be a repeat commission fee, again for the 0.1%, and you sell your 5000 CFDs.
The market overall moved 3.5c in the direction you predicted. Your closing value is $28500 (5000 x 570c). Your opening value was, of course, $ 28325 (566.6 x 5000), giving you profit (before commission) of $175.
The losing scenario - If share values had fallen, against your prediction, to 563c, -3.5c in other words, your closing trade would then have been $28150, giving you a loss of $175 overall. In this case, you likely have the cost covered, but remember that a loss can drop below available funds in certain circumstances.
As you can see, this can be an interesting way to hedge on an existing portfolio, as it's rather more liquid than some of the physical commodity instruments available. Start trading CFDs today!