Trading

The Pros and Cons of Trading CFDs

If you are interested in trading the capital markets, you should know about contracts for differences (CFDs). These securities allow you to speculate on the direction of a security without having to post the entire value of the assets. If your goal is to generate capital appreciation, as opposed to earning a dividend by using a buy and hold strategy, then CFDs are the right instrument for you to trade.

What is a Contract for Difference?

A CFD, is a trading instrument that allows you to speculate on the direction of an underling asset.  For example, a CFD on Apple shares tracks the changes in the price of Apple. If you buy it at $175 and sell it at $185, you make $10 per CFD.  You will find that retail forex brokers offer CFDs for traders in nearly every country.  Some brokers will offer CFDs on shares as well as indices, commodities and fixed income products.  There are also CFDs that track specific ETFs.  So, if you are interested in trading a sector of the market, a CFD will help you accomplish your goals. You can learn CFD trading through a reputable forex broker.

What is the Difference between CFDs and Shares?

There is a difference between CFDs and shares which leads to a difference in the trading strategy you use for each of these instruments.  Investors who are interested in a buy and hold strategy where you receive a dividend from holding shares, should steer away from CFDs.  Most CFDs will not pay a dividend.  The benefits of trading a CFD as opposed to purchasing or selling shares is that you do not need to post the entire value of the shares when buying them.

CFD trading is based on margin trading where a broker will calculate the maximum they believe you can lose on a given day and make sure your account holds that amount of capital.  For example, if a 3-standard deviation move on Apple shares is $10 per share, then a broker will likely require that you post $10 to purchase 1-CFD of Apple shares.  This compares to $190 for the share price which means that you can leverage your trade at 19-1. Each index share or commodity will have a different leverage ratio, and many retail forex brokers advertise leverage of 20-1 on CFDs.

Trading Strategies

There are several trading strategies that you can employ with CFDs.  You can trade CFDs around earnings or economic events.  You can use technical strategies such as momentum, sentiment or trend-following. You can generate a market neutral trading strategy where you buy one share and sell another.  For example, you can buy an Apple share CFD and sell a Facebook share CFD.

There are technical strategies such as Bollinger bands that can help you generate buy and sell signals on a pair of shares. You can also do this with commodities like gold and silver or indices like the S&P 500 and the Nasdaq 100.

Summary

Trading CFDs allows you to speculate on the direction of a security. CFDs provide you with leverage but generally do not pay a dividend. You can trade CFDs outright or create a spread and use a market neutral trading strategy.

Leave a Reply

Your email address will not be published. Required fields are marked *