- What is a CFD? And How is it Different from Shares Market?
- Is there Leverage with CFDs?
- Example of Trading CFDs Stocks relative to Stocks via Exchanges
- What is Margin in CFD Trading?
- How to Use Risk Management?
The recent stock market volatility has brought back the allure of trading the equity market, but unless you know what instruments to trade, it’s so difficult to make money unless you have a lot of money. When you trade stocks, most brokers require that you post nearly 100% of the price of the shares. Some broker offers margin, but in many cases, the amount of leverage they are willing to offer you on stocks is still not insufficient. It’s hard to make money on a small budget unless you trade stocks using a security called contracts for differences (CFDs).
What is a CFD? And How is it Different from Shares Market?
A contract for differences is a security that allows you to trade the difference in the price of an asset as opposed to owning or shorting-selling the security. When you purchase a stock from a broker, you own the shares and you are entitled to vote for issues that affect the company of the stock you own. Additionally, if the company issues a dividend you are entitled to receive that dividend. When you own the CFD’s of shares, you own the profit or loss created by the change in the price of the shares. You are not entitled to vote on company issues and you cannot receive a dividend. CFDs are geared toward making money from directional changes in the price of a stock.
Is there Leverage with CFDs?
When you trade CFDs you are taking advantage of the leverage that is provided to you by your CFD broker. Several brokers, including reputable brokers such as markets.com, provide CFD leverage that is 10-1 but please be aware that your capital is at risk. This means for every dollar you post to trade a CFD, markets.com will lend you $10 to enhance your trading returns. Leverage cuts both ways. It can help you generate better than average returns, but it can also provide you with the fuel to experience significant losses.
Example of Trading CFDs Stocks relative to Stocks via Exchanges
Let’s look at an example of how you can benefit using CFDs to start to trade a stock portfolio. We can look at Apple stock as it is widely traded stock and one of the most liquid stocks available. If you have a portfolio of $500 dollars, you would be able to purchase 3 shares of this stock which is currently trading around $165 per share. If the stock price increased by 10%, over the next 12-months, you would gain $49.5 which is calculated by multiplying $16.5 by 3. When you trade contracts for differences you are not purchasing the stock, so your exposure can be a lot larger than if you were purchasing the actual shares.
Brokers like markets.com will provide you with a leverage of 10-1 to trade a CFD on Apple shares but please be aware that trading CFDs carries a considerable risk of capital loss. This means for the same $500 dollars, you now have access to approximately $5,000. Instead of being able to only purchase 3-shares of Apple stock, you can now purchase 30-shares. If the price of Apple increases by 10%, you would make $495 dollars on your CFD ($165 * 10% * 30). The returns would be 99% instead of 10%, which would allow you to substantially increase your returns. It’s not too hard to see how you could quickly build a $500 portfolio to $1,000 or even $5,000 especially if you can develop a successful track record.
Obviously, leverage can cut both ways. If you lose 10% on the leverage of 10-1, your entire portfolio could be wiped out. For this reason, it is important to employ robust risk management to make sure that you live to see another day.
What is Margin in CFD Trading?
When you enter a CFD trade, your broker will require that you have a specific amount of capital in your account. The amount of capital is your initial margin. The margin required is the amount of capital needed if the price of the CFD moved against you by a larger than the normal amount. Generally, this is a 2 or 3-standard deviation move that only occurs between 1 and 5% of the time.
The margin calculation is real-time, and it tells your broker the minimum amount of capital you must have in your account to continue to hold your position. If an adverse change in the price of the CFD you own occurs, your broker will require that you post additional margin. If you are unable to increase the capital you have in your account, your broker will begin to liquidate your position. Make sure you completely understand your broker’s rights to liquidating your position before you start to trade CFDs.
How to Use Risk Management?
When you trade CFDs you should use a strategy that allows you to generate gains over the long-term. You should minimize the amount of money you place on any trade to 10-20% of your portfolio. So, if you are planning on trading a portfolio that is $500, keep the amount of money you post to $50-$100. This will give you the room you need especial if the first couple of trades you place are unfavorable. Another concept you should follow is to cut your losses and let your profits run. If the market moves against you and hits your stop loss, you should exit and live to see another day. If the market moves in your favor, move your stops up and let your gains compound as the market moves in your favor.
Several CFD brokers provide access to currencies, indices, commodities, and stocks. Most issue a small selection of liquid stocks and there are a few that have a plethora of stocks to choose from including shares from around the globe like Markets.com. If you are focusing on trading individual shares, CFDs provide investors with leverage that will allow you to generate robust returns with a limited budget. Regardless of the size of your portfolio, it’s important to use prudent risk management techniques when trading CFDs as your capital is at risk.
This article was originally posted on FX Empire
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