What Is It, How It Works, And Why You Need to Know About It
CFD trading is essentially trading without owning the underlying assets. If you’re trading CFDs, you’re typically making a contract that states that you’ll pay (or get paid) the difference between a specific asset’s prices at the current time and the time of the contract. So, if there’s a price change between the trade’s entry and exit, it must be paid, as per the contract.
Why do CFDs matter to traders? Because they are a fantastic way to gain exposure. You can enter the market without actually owning any underlying assets. That means that you don’t need massive investment and trading funds to begin your journey. Not to mention, with CFDs, you can go both long and short.
Because CFDs allow you to trade with leverage, they aren’t only accessible to a chosen few. Leverage is borrowed funds that you use to improve the potential return of an investment. Thus, you can gain more exposure with less capital.
Greater leverage seems like an indisputable benefit to most beginner traders. However, it’s the proverbial double-edged sword of trading. More leverage means that you don’t need to invest as much money as you would have to with other types of trading. But it also means that your risk of loss is more significant than it would be. Why? Because all your market movements (be they losses or profits) are calculated at full position value.
Trading Stocks vs. Trading Stock CFDs
The main difference between CFDs and trading stock shares (or any other trading, really) is in the ownership. When you trade stock CFDs, you aren’t taking ownership of the underlying assets. You’re only speculating on their market price and making a profit if you’re right.
However, when trading stock, you need to actually own the shares you’re trading (in most cases).
The main advantages of CFD stock trading lie in its other differences to share trading:
How Does Trading Stock CFDs Work?
In order to fully explain how trading stock CFDs works, we’ll give you a simple, plastic example.
Let’s say you want to enter the market and have your eye on Microsoft shares. Let’s also say that one share is $100 (isn’t that the dream) and that you want to enter into a CFD for ten shares. So, that’s ten shares, times 100 dollars each, which equals $1,000. But, don’t forget, CFDs allow for leveraged trading, which means you don’t need the whole $1,000 but only 20% of the entire value (because the leverage is 1:5).
So, you have to deposit $200 (20% of the entire value) and have enough money in your account to open and maintain your position.
Then, you have to pick a direction. Do you think that Microsoft shares will increase in value? Then go long and open a Buy position. If you think they’ll decrease, do the opposite. Keep the position open as long as you think you should to see how the price behaves, or set up close at a loss or close at profit stops that will close your position at a predetermined price.
The Importance of Understanding the Stock Sectors
The stock market has several sectors. They structure the market and are simultaneously independent of each other, and work in tandem. Sectors and industries often move together, which is why a trader needs to understand the sectors and their connections in order to trade on the stock market.
As mentioned, there are some common currency pairs that traders usually deal with:
Risks You Are Facing When Trading Stock CFDs
CFDs are a mellow version of high risk, high reward deal. They have a multitude of benefits, but they also come with their own set of risks. Aside from the fact that your losses can exceed your deposit, CFDs also have other risks:
- When you enter the CFD as an investor, your initial position immediately gets decreased.
- There’s a weak industry regulation, unlike with stock trading, which is highly and rigorously regulated.
- CFDs have a potential lack of liquidity, and the markets are volatile.