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Here is a really simple but useful tutorial on CFD trading that will get you up and running very quickly if you are new to CFD trading.
By the time you finish this article, you will know how CFDs work, what makes them highly profitable and understand the costs involved in CFD trading.
CFD stands for Contracts for Difference, a derivative product where you profit from changes in stock and share prices.
For example, if you buy CFDs on a stock at $5.00 and the price rises to $5.50, you profit from this change in price. So if you bought 1000 CFDs, your profit is $500. So, the value of CFDs reflects the underlying stock prices and you can profit from this movement.
Here are the reasons why CFDs are a very popular trading product and understandably so:
1. CFDs are traded on leverage, and this leverage is typically 10 to 1, with some CFD brokers providing 20 to 1 leverage. This means that a trader with a small float can make decent profits from stock market trading using CFDs. For example, you might have a stock trading system that returns 30% per year. On a $5000 swing, that’s a profit of $1500 in a year. With CFDs, due to leverage, the same system can now return 300%, which means a profit of $15 000 in a year.
2. You can also easily short sell CFDs and thus profit from falling markets. This greatly increases the profitability of a trading system because trading opportunities increase significantly and you can profit from both bull and bear markets.
3. Costs in CFD trading are relatively low compared to stocks. This is especially so because for a similar and often smaller cost per trade, you can get 10 or more times the result from one trade due to the leverage available. The 2 main costs in CFD trading are interest and leverage. We will touch on these in a moment.
4. You can set automatic stop losses. This means it will take you less time to place a trade, eliminate the feeling of exiting a trade when you should, and allow you to exit when the stop is reached, not a day later. Therefore, you avoid slippage due to exiting a trade later than you intended.
5. You can place all your orders in the evening. With many CFD providers, you can place orders to enter a position the night before. For working people, this is a big advantage because they can do all their trading (place entry orders and stop-loss orders) in the evening and don’t have to be at their computer screen or call their broker during the day. Also, if they have any stop losses that need to be set, they can do that in the evening as well. Their trading routine with a mechanical system can be about 10-15 minutes a day.
So these are the advantages of CFDs that make trading accessible to so many people because they provide great returns for modest volatility and they can also be traded once a day.
Now, we mentioned that there are 2 main costs in CFD trading. Let’s take a closer look at each of them:
1. Commission. With some CFD providers there is actually no commission. This greatly increases the profitability of your CFD trading systems and also the fact that you can benefit greatly from leverage. Other CFD providers may have a commission of 0.15% of the trade size or $15 (whichever is greater). These costs are similar or less than the commission associated with stock trading, especially when you consider the multiplied profits that leverage gives you.
2. With CFDs, interest is charged on long positions held overnight. Interest is paid to you for short positions. The amount of interest charged is usually a reference rate plus about 2% and the interest paid is usually the same reference rate minus about 2%. And the reference rate is usually the overnight rate of a major bank.
For example, the interest rate for long positions held overnight might be 7.5% or 0.075% per annum. To calculate how much that is for a trade, we need to “pro-rate” it. That is, we need to divide 0.075 by 365, buy the number of days in the trade and then multiply by the trade size. For example, for a $10,000 trade held for 14 days, the interest cost is about $28, which is not a huge cost. For a short trade, the interest is paid to you, so it will offset the cost instead of adding to it.
So there you have it.
You now understand the benefits of CFD trading and why they are a trading instrument that allows people with a modest surface to make very good returns and the costs associated with CFD trading.
