CFD Basics
CFDs
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Contracts for difference (CFDs) open up a whole new range of opportunities to the active trader. The access to leverage, the ability to trade long or short and the flexibility to enter or exit a trade at market prices when you choose are now available to all traders. Having these tools at your fingertips provides a great opportunity and also requires the trader to implement rules to ensure survival in the market. |
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When sailing in the oceans, anything can happen: from massive storms to long calm periods. The oceans and weather are unpredictable and we have no control over them; however, sailors can safely navigate around the world.
Its exactly the same with the markets. No person can reliably predict the stock market, and certainly no individual or company can control it. Yet it is possible to safely navigate the market and profit from it using CFDs and many other instruments.
Long vs. Short
Most traders are familiar with trading long: Buying shares and selling them for higher prices
to make a profit. When trading CFDs, it is just as possible to make money trading short as it is
trading long. When trading short, you sell the share, then buy it back later, hopefully at a cheaper price.
This confuses many people because how do you sell something that you do not own?
The mechanics
behind it works like this: Imagine borrowing your neighbour’s lawnmower and selling it for $500.
You get the $500 now, but at some point in time, your neighbour is going to want his lawnmower back
(unless he’s very generous and lets you keep it – most neighbours aren’t like that!).
If you can buy the lawnmower back for $300, then you can return the lawnmower to your neighbour
and you get to keep the profit of $200. If however, you have to buy it back for $600,
you have just lost $100.
This same mechanism is used in the stock market to short sell shares. However, in the plain stock market, its not that easy to short-sell a stock, due to the uptick rule which stipulates that a short seller cannot sell a stock short unless on an uptick or a zero-plus tick; this means the stock can only be sold short if the last non-zero “tick” (i.e. trade price) was higher than the preceding one.
Go Either Way With CFDs
With CFDs (and all derivatives in fact), you don’t have this problem. If you buy
a CFD at $10 and sell it at $12, you settle for the difference, a profit of $2 (ignoring
commission and interest charges). If you sell a CFD at $12 and buy it at $10 you
again keep the profit of $2. Short selling with CFDs is easy: the CFD provider takes
care of the mechanics behind the short-selling process; all you need to do is click
“sell” instead of “buy” to enter a position.
Benefits of CFDs
Leverage
CFDs are NOT a fix for poor performance when trading outright stocks. They offer an opportunity to
move you well beyond the returns offered by trading shares, but they will also amplify the downside
when things go wrong. This is the effect of the two-edged sword called leverage.
CFDs Are Simple
Unlike with options or warrants, understanding the mechanics of CFDs is relatively simple.
But the key to your success is not this understanding, but rather your risk management and how
you cope with the ups and downs as a trader. Coping with the psychological impact of large wins or large losses when trading CFDs will be a key component to your success.
CFDs Offer Variety
CFDs are a revolution in trading. No other instrument offers the variety of underlying securities
that CFDs do. The world’s markets offer an unlimited opportunity and using CFDs, traders can now
choose exactly what they would like to trade, when they would like to trade and how much they would like
to trade: A trader could buy shares locally in Australia, short-sell a share in the United States, buy
another share in Japan, trade on an index in Europe or trade a currency anywhere in the world!