Contracts for difference differ compared to other investing methods such as buying stocks. They allow you to use a small amount to magnify your gains. They also respond well to traditional trading strategies and are cheaper to trade in countries where stamp duty is applicable to stock ownership. To get started with contracts for difference as an investment option, here is what you need to know.
What Are Contracts for Difference?
Contracts for difference (CFDs) are derivative products that allow investors to speculate on market movements. CFDs enable two parties to trade financial instruments such as commodities and foreign currencies based on the difference between the entry (buying) and closing price (the price of a financial instrument at the end of a trading period). The trading period often ranges from a few minutes to about two weeks, depending on the trader’s strategies and their preferences.
To make a profit, the closing price has to be higher than the opening price, meaning that the buyer has to pay the difference between the two. If the closing price is lower, the buyer makes a loss. Sellers benefit from the trade when the current price of the financial instruments they hold is lower when they exit than it was when they opened a contract or entered a trade.
Protecting Your Investments
When trading CFDs, you must be good at predicting the direction of a market. The best way to get to grips with this is via extensive research. However, some of your positions and trades will be wrong, and this is why it is so important to be able to pull the plug when a market is moving in the wrong direction.
A stop-loss order acts as an alarm that tells you when a stock or position starts moving in the wrong direction. When set up the right way, they can help stop losses before you have enough time to manually intervene. Fortunately, a reputable CFD trading platform such as easyMarkets makes it simple to set up stop-loss orders; this provider in particular is an example of one that provides free, guaranteed stop loss – particularly useful for new traders.
Leveraging in CFD Trading
One of the most important things to remember when trading CFDs is that they are leveraged. Because they are leveraged, you can get exposed to a larger position than your initial investment without having to invest the full amount of the investment. This is quite different from trading traditional shares because you would have to pay the cost of all the shares you want to buy upfront. With CFDs, you might need to pay a small percentage of the upfront cost.
Although this helps your capital work harder for you, it also magnifies your losses if the market, commodities, or financial instruments you are invested in move unfavourably. This is because your losses are calculated according to your full position, which is larger than your initial outlay due to the leverage. This is the reason why it is important to pay close attention to any leverage ratios applied to your trades to ensure you are shielded from massive downward market swings.
Contracts for difference trading can be a potentially beneficial short-term investment option for those who understand it well. But the markets are complex and it’s essential to gain an understanding of how trading works before diving in. Learning the basics of CFD trading will help you become a better trader and put you in a better position to avoid losses. Once you understand the basics, it is time to get in touch with a reputable broker to start investing.
----
NOTE: This is not financial advice. This article is only for information purposes, please consult with your own financial advisors and do your own research when making any trading or financial decisions.
