Contract for Difference (CFD) is gaining in popularity, as they allow investors to gain access to more financial assets in the market. As the name implies, it opens a contract between two parties, the 'buyer' and the 'seller', and the value of the CFD is dependent on the difference in price of an asset you decide to open and close at any point in time.
CFDs are attractive for the low capital required to get a sizeable market exposure. You can trade across a variety of asset classes such as shares, indices, forex, exchange traded funds (ETFs) or even cryptocurrencies. Trading CFD allows you to speculate on future value of an asset without the need of owning the underlying asset.
What's more, when you open a CFD with a brokerage, you are dealing on a single, unified platform that brings all the markets together. That means no separate forex provider, stock broker or futures exchange for you to trade with concurrently.
The benefits are multi-fold and it's understandable that your interest is piqued by what you can achieve when you trade with CFDs. But just like any sports or games you play, it's crucial to know where you stand before engaging in the actual event.
Before you make that exciting first step into the CFDs trading world, here's a beginner's guide to CFDs and its potential to grow your financial portfolio.
Utilise the financial management tools at your disposal
CFD trading is all about managing when you open or close your position at specific points, mainly to increase your profit margin and reduce potential losses.
User-centric tools such as limit order, which closes at your specified profit point, is especially useful when you need that automatic nudge to reap the rewards without going too far into the game.
Consider this - if you bought an asset at $9 and set the limit order at $11, that's a guaranteed $2 profit once you reach the limit order. As a beginner, it's more important to be prudent - know your limits and set it within a safe parameter to enjoy a decent profit.
Equally important are stop-loss measures, which close out at the position you desire and keep your losses in check. One way to mitigate this risk is by applying a guaranteed stop on your position, which assures that you only pay for the triggered position which you specified and be protected from slippage.
For beginners, this is especially important and brokerages recognise the need to protect its customers from losses due to the reaction time between the trigger and actual closing, which might be worse than the triggered point due to the sudden drop asset price.
Maximise your rewards with the right tactics
Let's assume you have a very basic understanding of trading and CFDs. You can beef up your knowledge base and read up on a whole slew of guides in 30 minutes.
Established brokerages such as IG have comprehensive guides that can help you start off slow with the basics of trading, to diving in on the various risk-management tactics such as looking at a risk vs reward ratio in your favour.
The risk vs reward ratio is particularly important, and it should be your first consideration before you trade. Balance and weigh the rewards with the associated risk, access to see if the risk taken is comparable to the expected reward the investment can offer you. The good thing is both risk and reward can be easily managed through the right limit order and stop-loss as mentioned earlier.
Simply put, your limit order can be on the higher spectrum, to increase your profit margin. But to ensure you minimise the risk involved, you need to set a more conservative stop-loss point. A good point to measure is a 1:2 risk vs reward ratio - or essentially a 2x stop distance between the limit order and stop-loss point.
Leverage - making more with less
As a relatively newcomer to the CFD game, you will need as much help as you can get. This is provided by most brokerages in the form of leverage, which lets you trade on CFD with a relatively low capital outlay.
Leverage, as the name implies, gives you an advantage and in this case, allows you to gain a large exposure to an asset with a small amount of trading capital. Instead of paying the full purchase price of an asset, leveraging allows you to fork out only a fraction of the cost for the same asset amount.
To illustrate, consider 1,000 shares of XYZ company with a share price of $1. Rather than making you pay $1,000 to buy the 1,000 shares, brokerages that offer leverage facilities could only require 5% of $1,000 as a margin or deposit requirement.
In essence, you only need $50 to have exposure to the same 1000 shares as you would with a full purchase. What happens if the shares are on an upward trend, ending at $1.20 and you decide to close at that price? You are selling it at $1,200 or to put it in profit terms, you've made $200.
And that's done with just a $50 capital overlay, which translates to a 400% profit.
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As a beginner, leverage is very attractive for its relatively low cost with a high profit margin. While the above example deals with a modest sum of money, consider the amplified gains you are looking at for assets with a higher share price and potentially being able to amplify your gains without stretching your dollar.
One caveat - while you enjoy an amazing profit margin with leverage, you have to guard yourself against an equally amplified loss too. But as a beginner, it's all about managing your risk vs reward ratio and ensuring your stop-loss is at a safe level to keep your capital intact.
Find a trustworthy brokerage and community
This might seem like common sense but it's important that the brokerage you entrust your money with is reputable. There are a few ways to check against the brokerages reliability, and the most obvious one is to look for accreditation. In this case, a stamp of approval from the Monetary Authority of Singapore (MAS) is the best credential you can get it.
For example, IG holds a capital markets service license from MAS for dealing in securities and leveraged foreign exchange trading and is an exempt financial advisor, so that's one check box ticked for reliability. On top of that, it is also licensed by International Enterprise Singapore to trade CFDs on commodities.
You can also gleam more information from word-of-mouth too. Personal finance communities such as Seedly can provide a good source of testimonials. Seedly is also a good forum to seek finance advice on a personal level, giving you a lead towards where you should read up more about CFDs.
Okay, so you're ready, what's next?
The game plan we laid out above is just the bare necessities for a beginner's first step into CFD trading. There is more to learn when it comes to CFD trading, or trading in general.
The act of buying an asset in anticipation of it rising and selling at a higher price to gain profit is going long. This is a very straightforward way of trading and something that beginners are more comfortable with.
But there's also the possibility of going short, where you sell to open a short trade and buy to close it. This is mainly done when you expect an asset to fall rather than rise. This is done in the hopes of buying the shares back at a lower price, thus netting you a gross profit (minus the broker's commission, borrowing fee and other costs for the trade).
In the case of CFDs, brokerages are doing you a huge favour because you do not borrow the stock. Remember, CFD is about entering a contract with the brokerage for the difference. They are the ones who execute the opening and closing of your position, giving you the peace of mind during late hours when you aren't able to monitor the market.
This is especially important when you go short, when the market needs to be observed closely to prevent any sudden losses. Brokerages such as IG have round-the-clock monitoring in placed, to ensure that your limit order and stop-loss are implemented on your behalf.
There are also advanced techniques that looks at how you go long or short, depending on the market movement. You might have a particular stock going long and it's perhaps giving you a dividend of 5% per annum. But market research has shown that there's a chance it will adjust downwards. The prudent move is to sell your portfolio and quit while you're ahead.
But that was in the past. Now, you have the option to go short with the same stock using CFD. Remember, with CFD, you are not owning the stock and the margin you are paying is relatively low. Hedging, as this move is known, reduces your risk by offsetting multiple positions. In this case, you are looking at protecting your long portfolio, but also taking care of any potential downsides by going short through CFD and trading on the downwards trend.
On top of that, the huge range of assets you can get via CFD also means you don't limit yourself to just forex or indices - you can potentially hedge through multiple different assets to protect your investment.
For the more advanced CFDs trader, there's also pair trading that basically requires you to go both long and short for two highly correlated assets, be it stocks, exchange-traded funds (ETFs), currencies and many more. Pairs traders wait for weakness in the correlation, and then go long on the under-performer while simultaneously going short on the over-performer, closing the positions as the relationship returns to its statistical norm. The strategy's profit is derived from the difference in price change between the two instruments, rather than from the direction in which each moves.
In the end, whether you are a beginner or advanced trader in CFDs, it's important to have the basics in place. With the knowledge you've obtained in this guide, you are now ready to take the first step in CFD trading. Get started with an IG trial account, use your $200,000 virtual funds wisely and formulate your game plan before the real deal.
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This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views, opinions and recommendations expressed in the article are the independent opinion of Go Bear and do not in any way reflect the views, opinions, endorsements or recommendations, of IG Asia Pte Ltd (Co. Reg. No. 20051002K) (“IG”). Information is for educational purposes only and does not constitute any form of investment advice nor an offer or solicitation to invest in any financial instrument. No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of this information or material.