Trading has always been popular in Australia, and more and more Australians are getting into investment and wealth management over the years. This has resulted in a sharp uptick in local and international providers, due to the increased demand for investment opportunities and improved accessibility. Alongside the growth of investment platforms available, the demand for financial education in the country grows.
This article is a response to this growing demand, and it will examine what CFD trading is, and how traders can benefit from it. Though there are risks in investing and there is no such thing as guaranteed profits, having sound knowledge of investing and the financial market can make a huge difference in the potential of trading success.
What are CFDs?
CFDs, or Contracts for Difference, are financial instruments that allow traders to speculate on the price movements of various assets without owning the underlying asset. CFDs work by allowing traders to enter into a contract with a broker to exchange the difference in price of the underlying asset between the opening and closing of the trade.
When trading a CFD, the trader selects the underlying asset they wish to trade, such as stocks, currencies, commodities or indices. The trader then decides whether they think the price of the asset will rise or fall, and they enter into a contract with the broker. If the price of the asset moves in the direction predicted by the trader, the trader makes a profit, but if it moves in the opposite direction, the trader will incur a loss.
An example of CFD trading
An example of CFD trading is buying a CFD contract for 100 shares of stock ABC at a current market price of $50 per share. If the price of ABC rises to $55 per share and you close the contract, you would earn a profit of $500 (100 shares x $5 increase in price).
On the other hand, if the price of ABC falls to $45 per share and you close the contract, you would incur a loss of $500 (100 shares x $5 decrease in price). The profit or loss is calculated based on the difference between the opening and closing prices of the contract.
Why do people trade CFDs?
CFDs are very popular instruments, and it is not difficult to see why they appeal to traders with their various advantages. Some of them include:
CFDs allow traders to control a larger position in the market with a smaller initial investment. This means that potential profits can be amplified, but it is important to note that losses can also be magnified.
CFDs can be traded on a wide range of underlying assets, including stocks, indices, commodities, and currencies. This allows traders to access a diverse range of markets and tailor their trading strategies to different market conditions.
No contract expiry dates
Unlike options and futures, CFDs do not have an expiry date. This means that traders can hold positions for as long as they want, subject to any overnight financing charges. This also means that CFD holders do not experience time decay.
Availability of a wide range of markets and instruments
CFDs allow traders to access global markets, including those that may be difficult to trade in other ways. This means that traders can take advantage of opportunities in different parts of the world.
Ability to go long or short
CFDs allow traders to take advantage of rising and falling markets by going long or short selling. This means that traders can profit from a decline in the price of an underlying asset, as well as from a rise, and they can find opportunities in both bullish and bearish markets.
Trading on margin
Finally, CFDs are typically traded on margin, which means that traders only need to deposit a fraction of the full value of the position. This can increase the potential return on investment, but it is important to be aware of the risks involved.
What are some ways to trade CFDs?
There are many ways to trade CFDS. Some of the most common methods include with direct market access CFDs, through market makers, and through other products, such as ETFs, Indices, and Commodities. Let’s look at them a bit more in-depth.
1. Direct Market Access (DMA) CFDs
DMA CFDs allow traders to trade CFDs directly on the exchange. This gives traders access to the full order book and enables them to see the depth of the market.
2. Market Maker CFDs
Market maker CFDs are provided by the CFD provider who acts as a market maker. They set their own bid and ask prices for the CFDs.
3. Synthetic CFDs
Synthetic CFDs are created by combining several different financial instruments. This allows traders to trade assets that they may not be able to trade directly.
4. ETF CFDs
ETF (Exchange Traded Funds) CFDs allow traders to trade CFDs on a basket of stocks or other underlying assets.
5. Index CFDs
Index CFDs allow traders to trade CFDs on a stock market index, such as the S&P/ASX 200 in Australia.
6. Commodity CFDs
Commodity CFDs allow traders to trade CFDs on commodities such as gold, oil, or wheat.
Overall, it is important to note that different CFD providers may offer different types of CFDs, and the trading conditions for each type of CFD may also vary. It is important to do your research and choose a CFD provider that offers the types of CFDs you want to trade and has favourable trading conditions.
When can one trade CFDs?
CFD trading is typically available 24 hours a day, five days a week, as most CFD providers follow the trading hours of the underlying market or asset being traded. However, some CFD providers may have restrictions on certain instruments or trading hours, so it’s important to check with your specific provider for their trading hours. Additionally, CFD trading may be affected by public holidays or events that result in market closures or reduced liquidity.
Risk management techniques for trading CFDs
CFD trading can be a potentially profitable investment strategy, but it also involves significant risk. Therefore, managing risks is an essential part of trading CFDs. Here are some risk management techniques that can be applied while trading CFDs:
- Stop-loss orders: One of the most popular risk management techniques is using stop-loss orders. A stop-loss order is a pre-set order that automatically closes a trade if the market moves against the trader, limiting potential losses.
- Hedging: Hedging is another strategy to manage risk. It involves opening a trade that will offset potential losses in another trade. For example, if a trader has a long position on a stock, they could open a short position on a related stock to offset potential losses.
- Diversification: Diversification is a strategy to spread risk across different assets. By diversifying a portfolio, a trader can reduce exposure to the risk of any single asset. Diversification can be achieved by trading CFDs on multiple assets, such as stocks, indices, currencies, and commodities.
- Proper trade sizing: Proper trade sizing is essential to manage risk. Traders should not risk more than they can afford to lose in any single trade. A common rule of thumb is not to risk more than 1-2% of the trading account balance on any trade. However, this is not a rule nor should it be construed as financial advice.
The bottom line
CFDs can be an exciting investment activity, and it is certainly one that is popular in Australia. However, they are slightly more complex than traditional trading, and some investors may find it is worth doing extra research on how these contracts work and on the market that they want to trade. There are certainly no guarantees of profits in trading, and participants should be aware of this and not trade with more money than they can afford to lose.