CFD Trading is one of the most attractive forms of short term trading for many reasons.
Firstly, it is far more liquid than option trading and if your broker or market maker provides realtime market spreads, the bid and ask price will be much closer together.
Secondly, your trading platform will usually allow you to trade many more markets besides your local stockmarket - and because the “many more” includes overseas markets, you can do it around the clock if you wish. This can be very attractive to those of us who work a day-job and like to put trades on at night. You can usually include a stop-loss as part of your trade entry, which gives you peace of mind.
One of the most popularly advertised “benefits” of CFD Trading is the leverage. This is great if the price of the underlying share is going in the direction you anticipate - but betware if it’s not. Unless you take out (and pay for) a “guaranteed stop loss” you have unlimited … let’s use that word again … unlimited exposure to price direction.
Let’s take an example of how this leverage works. Say the price of ABC stock is currently at $20.00 and you think it may rise within a short timeframe. If you had $1,000 to risk and you were going to purchase the actual shares, you could only buy 50 of them. If the price rose to $21.00 you would make a $50.00 profit, less brokerage - not much eh!
But if you used that $1,000 to purchase CFDs and they were leveraged at 5%, this means your broker or market maker finances the other 95% of the purchase price and charges you interest for it. It’s like margin lending on steroids. So now, your $1,000 will allow you to be exposed to 20 times (50 divided by 5%) the number of ABC shares. You now have a contract over 1,000 shares, which means if the share price rose to $21.00 you now make a $1,000 profit instead of $50. That’s how leverage works.
But should the price of ABC shares drop to $19.00 your highly leveraged instrument will work against you. Your $1,000 profit from the previous example will now become a loss of the same amount. If some unexpected news came out and the price gapped down overnight and opened $3.00 below the previous day (i.e. $17) you’re suddenly in a loss situation of $3,000. If your worst nightmare was realized and the company went into liquidation so that the shares were now worth nothing, your loss would amount to the whole $20,000 you controlled.
On the downside, the most your share price can fall to, is zero, therefore the most you can lose is the $20k in this case. But on the upside, there is theoretically no limit to how high a share price might rise. If you had gone short (sold) ABC Shares, you make a loss if the price rises.
So if you’re thinking of trading Contracts for Difference (CFD’s) it is a good idea to look for a dealer who only leverages at 10%. This means they finance the other 90% of your trade (not 95%) leaving you less exposed to short term market movements. Your profits aren’t as great either, but the peace of mind is well worth it. In the past, I’ve had so many trades stopped out before they took off in the direction I believed they were going anyway - all because my leverage was too high. If you use CMC Markets, they leverage blue chips shares at just 3% (scary!). If IG Markets is your dealer, they’re a bit better at 5%. But there are other dealers out there, who will give you contracts at 10% leverage.
For further information on CFDs including time-tested trading strategies that consistently work, Nik Halik runs home study seminars called CFD Mastery.
To visit his website, click on the picture below.
Nik Halik and CFD Trading
