Published: 18 November 2020 by Andrew
If you are reading this guide, it is perhaps because you are curious to know more about CFD trading. Or maybe you have already started making some investments with this derivative instrument, and you want to have more information on how you can relate to the best strategies with CFD trading.
Whatever the motivation that drove you here, and whatever your level of financial knowledge is, we have good news for you. In fact, we want to share a series of information that will be very useful for improving your investment strategy with Contracts for Difference!
First, though, we want to give you a little initial tip.
In order to make the most of the information you will find below, open a trading account with eToro (official website), one of the best online brokers in the world.
In this way you can use its demo account and, consequently, put into practice what you will find in the next paragraphs without any delay and in total safety!
Having clarified this, let’s kick off our guide on CFD trading!
What is CFD Trading
Let’s start right from the basics.
We define the CFD – Contract for Difference – as a contract between two parties, through which they agree to pay the difference between the opening price and the closing price of a particular underlying financial instrument.
Therefore, there is no actual purchase or sale of financial instruments, but only the existence of an agreement (in this case, between the Trader and the Broker) to regulate the difference in value between the opening and closing price of the position.
With these specificities, investing in CFDs is a way to speculate on the price movement, without owning the underlying asset. You can therefore try to earn with CFD trading without getting hold of gold, currencies, cryptocurrencies, commodities, stocks and much more!
The mechanism is quite simple. Indeed, the performance of the CFD reflects the price and the price trend of the underlying asset. Profit and Loss are established constantly, as the value of the underlying asset moves relative to the position of the opening price.
So, when you close the position of a CFD with the broker, you will get:
- A loss: if the price, of the underlying asset, moved in the opposite direction to that which you expected
- A profit: if the price, of the underlying asset, has instead moved in the same direction as you expected
For now, keep these concepts in mind:
- When trading a CFD with a broker, you do not own the asset you negotiate, but you are only speculating on the movement of the price, Up or Down
- It is not necessary that the market was always growing. In fact, you can also make a profit in a declining market, provided you have correctly predicted the direction
How CFD Trading works: an example
In order to understand, even more clearly, how CFD trading works, let’s make a practical example.
So, imagine that you want to invest in a share that is listed on the Milan stock exchange for 25 euros, and that you want to invest in 100 shares of the company. It follows that, if I had to buy a share in the traditional way, the budget to be allocated for this operation would be 2,500 euros (25 euros x 100 shares). You will also need to add commission or negotiation costs to this, which could further erode your margin of profit!
With CFDs you can operate in different ways:
- You can, for example, trade CFD stocks without leverage. In this case you can carry out the same operation as above, with even greater simplicity and without paying commissions and other charges;
- You can trade CFD stocks with leverage. For example, if you want to invest in stocks with 2x leverage, it means that in order to open a position of 2,500 euros you should only deposit 1,250 euros. The other part will be “loaned” to you by the broker, which will therefore allow you to immobilize less capital, while aiming for greater profits (but be careful, the losses will also be greater!).
But, why is CFD Trading free (commission free)?
The reason is that brokers get their income in another way: Spread.
When you open a position with a CFD, you will notice that the position will be opened immediately with a small “loss” equal to the size of the spread. This means that if your broker’s spread is 5 cents, then you will need the stock price to be at least 5 cents to reach the breakeven point.
Profits and losses in CFD trading
We continue to deepen the functioning of CFD trading with the example above. So, let’s imagine that the price of the underlying security continues to rise and reaches a price of 26 euros, from the initial 25 euros.
In the event that you have invested in CFD trading without leverage, then now your capital is worth 2,600 euros. A nice profit, net of the spread, equal to 100 euros.
If, on the other hand, you had invested with 2x leverage, you would still have made a profit of 100 euros, but immobilizing half of the capital. So, in terms of percentage, the CFD would have returned you much greater profits! Be careful, though: if the market had moved in the opposite direction, in fact, even the losses compared to your initial investment would have been greater. Remember, therefore, that both risk and profit are greatly increased due to leverage, and that you should handle this tool with particular care.
Read also: The best platforms for online trading
CFD Trading: Benefits
At this point, you should have already understood what the main advantages of CFD trading are. However, let us try to clarify them, in a synthetic list.
The leverage of CFDs is one of the reasons why trading with Contracts for Difference is often and willingly used, rather than direct trading with the underlying assets. The financial leverage provided by brokers such as eToro (official website) essentially depends on the type of financial instrument (it is lower for cryptocurrencies, for example, while it is higher for equities).
Thanks to leverage, you can take on large positions with less capital. Careful, however: as we have already had occasion to remember a few paragraphs ago, although in this way it is possible to gain large numbers faster, it is also true that the losses will be much larger.
The best CFD brokers such as eToro (official website), Trade.com (official website) and Plus500 will allow you to operate in all the main financial markets of the world, even 24 hours a day (thanks, for example, to Forex).
In short, you will have access to an infinite number of opportunities, within which to choose the ones that best refer to your financial strategy.
Trading with CFDs has minimal costs. The best traders that we report on this page do not charge any commission to enter and exit positions because, as we have already mentioned, they earn their profits with the spread. The extent of the spread will depend on the volatility of the underlying asset and, as a rule, has decreased in a fixed amount.
Even if in some moments it will not be possible to make Short Selling (as happened on some occasions in the coronavirus epidemic), with CFDs you can earn both with a growing market and with a decreasing market.
In short, you will not necessarily have to wait for the market to be in a growing phase in order to earn: it is sufficient that you correctly predict the evolution of the prices of the underlying asset you want to trade.
CFD Trading Risk
Of course, like any financial sector, CFDs also have risks that you should not underestimate.
The CFD sector is not fully regulated. This means that it is essential to know how to choose the right broker to avoid all sorts of problems.
Below, the official list of the best regulated CFD brokers in Europe:
Min. Deposit: 50€
Min. Deposit: 100€
Min. Deposit: 50€
Min. Deposit: 100€
72.30% of retail CFD accounts lose money
Min. Deposit: 250€
Min. Deposit: 100€
Although, as we have already mentioned, the margin can increase your profit potential, the risk also increases!
It is very easy to lose sight of the total exposure that occurs when using a rather high leverage. For this reason, our suggestion is to start trading with CFDs without leverage or with a very low leverage.
Train using a demo account, such as the one you find on the official eToro website. Once you understand the functioning of the leverage, you can proceed with the completion of the CFD trading operations in leverage with real money.
CFD Trading for Beginners: how to do
Now that you have more information on what CFD trading is, what the advantages and what the disadvantages, let’s try to understand, step by step, how you can invest in CFDs with the best brokers on the market, such as eToro (official website) and Trade .com (official site).
Choose a Market
There are so many markets to choose from. For example, you can invest in currencies, commodities, stocks and indexes. Try to choose a market that you know well, especially at the beginning, because this will help you react to market developments with the right awareness.
Buy or Sell?
If you Buy, you go “Long”, if you Sell, you go “Short”. All major trading platforms allow you to invest in both directions with the same ease. Remember that the price of your CFD is based on the price of the underlying instrument. So if you have reason to believe that the market will grow, you should buy. If you believe it will decrease, you should sell.
How much to invest
Now you need to select the size of the CFDs you wish to trade. Brokers generally have rather low investment limits, thus allowing anyone to be able to start investing even with very limited capital.
Stop Loss and Take Profit
Imposing Stop Loss and Take Profit will help you better manage your profits and limit your losses. Most CFD strategies for beginners and experienced traders ALWAYS use the use of stop loss and / or take profit. So define them in line with your risk management strategy. Once set, the broker will automatically close the position down or up once the price has touched the set limits.
CFD Trading Strategies
Choosing a good market to invest in is not easy, but without an effective strategy it will be almost impossible to make a profit. You will therefore have to devote a large part of your initial efforts to finding a strategy that suits your trading style. But what are the best CFD trading strategies?
One is certainly “breakout”, which simply requires identifying a key price level for a particular security. When the price reaches the key level, you will have to buy or sell, depending on the trend. The main thing to remember with breakout trading is to avoid any trade when the market does not provide clear signals.
The second strategy is the “contrarian” one. In this case, your plan is essentially based on the awareness that trends don’t last forever. If the price of a security is falling, then a point is identified where it is believed to be near the end of the trend. Then, you enter a Buy position in anticipation of the trend turning in the other direction. Of course, you can follow exactly the same procedure if the price is rising!
We hope, on the sidelines of this study, to have provided you with sufficient elements to be able to understand correctly what it means to trade CFDs and what you need to do to start investing in contracts for difference.
Always remember that it is essential to choose a regulated broker to trade with, such as eToro (official website). And that before investing with real money, it is always good to train a little with a demo account!