The abbreviation CFD stands for “Contract for Difference”. A CFD is a form of derivative, a product whose value depends on the value of another asset. Instead of buying or selling an actual share in a company, CFD trading allows you to buy the right to benefit from increased value without taking ownership.
The most significant benefit of CFD trading is that it allows traders to make much bigger profits than they could through owning shares. Using traditional stocks, an investor could only make two times his initial investment due to government legislation’s limits placed on capital gains tax.
Because people are buying contracts instead of actual shares, they can buy twice as much before incurring any taxes. The potential to earn large sums very quickly attracts many investors into this market, though it also increases their likelihood of experiencing losses at the same rate. Have a look at Saxo to trade with CFDs.
An example of CFD trading
Let’s say Company X’s shares are currently trading at $5, and you think they’re going to rise above that price within three months. With CFD trading, you can purchase their shares through your online brokerage account and then sell them at $6 when you believe that price will be reached. If it does happen, you’ve doubled the money initially invested (fewer fees and interest payments if applicable). The same would be true if you had predicted a fall in the share’s value and so sold them for $4: you’d have doubled your money.
How can you mitigate the risks of CFD trading?
1. Do Not Over-Leverage and Always Remember to Diversify
Leverage is double-sided as it increases the potential rewards but also the risks. The higher your leverage, or margin as CFD brokers call it, the more you could make with every successful trade. However, if you are trading at a 100% margin, even small price movements can wipe out an investor’s entire budget.
If you think about what happened during the financial crisis in 2008 when stock prices dropped by 20% in one day after many months of increasing steadily, anyone holding shares with their whole portfolio would have lost everything instantly.
2. Start Trading on a Demo Account Before You Deposit Any Money
Many brokers offer to let you trial your CFDs package before committing any actual capital; this is called demo trading. This allows investors to get used to placing orders through their website and viewing real-time the performance of their portfolios without having to risk anything.
The only downside is that demo accounts don’t show how much interest will be applied to positions carried overnight or held for more than one day. So it’s worth considering whether demo trading is suitable for you; if you’re not sure, we recommend taking the time to read around other peoples’ experiences instead of blindly trusting your first broker.
3. Develop a Good Understanding of How CFDs Work
This may seem like an obvious tip, but many investors don’t understand how these products work and, as such, enter into trades that they don’t fully grasp. If you want to trade well, you must understand how a position develops based on various market conditions; this includes whether your broker’s platform offers the ability to make conditional orders and trailing stops.
These tools allow you to keep a position open when it seems like there is more room for growth and close it out when the price starts falling; they can also help mitigate losses if one of your predictions turns out to be wrong.
4. Keep Back-Testing Your Predictions and Rebalance Regularly
Back-testing is the process of using historical data to see whether a particular strategy would have performed well in the past. If you’re planning on making any significant amount of money through CFD trading, then it’s vital that you back-test your predictions for periods more extended than just one or two years. Ideally, you’ll want to look at ten or even twenty years’ worth of data to ensure your predictions will work under similar market conditions today.
This will help you avoid falling into what economists call survivorship bias; when we assume that something we observe only happened because we were there to see it, rather than assuming it was down to some external factor.