intro – trading cfd
Contract for Difference(CFD) trading is used to speculate on the movement of an underlying asset. On surface, it’s very similar to trading an asset(like stocks,currencies or commodities) directly, to profit from a favourable movement in market spot price. For instance you buy a CFD if you believe that the asset price will go up and you sell a CFD if you have a dovish view of the market. However, there are 2 key differences when it comes to trading CFD.
Firstly, when trading CFD, you never own the asset. So, there is no income(dividends), no voting rights(you do not own the stock). Secondly, when trading CFD, for the same capital, you can use leverage to take a much larger position, than if you held the asset directly. You do not need to put a large amount of capital upfront to gain a large exposure.
In the next sections, we will go through the history of how CFD’s came into existence. We will then look at structure of CFD’s in a bit more detail. Finally, we will look at the options available to an individual retail trader to start trading CFD.
a detour back in time
CFDs were originally developed in London as an efficient way for hedge funds, prime brokerages and asset managers to gain exposure to stocks on the London Stock Exchange. The buyer and seller of CFD’s never hold the actual asset so there are no associated costs – such as stamp duty. On the flip side, there are no voting rights or income(dividends) either.
This made trading CFD’s a very practical option to speculate or hedge portfolios for large institutional investors. When the size of these portfolios is in billions of dollars, the stamp duty and fees associated with owning a physical asset can run into millions. Therefore, this makes a physical asset an inefficient hedging instrument.
The trading was done on margin accounts. In other words, the trader of a CFD had to maintain a margin account balance with CFD market maker. And, based on the CFD contract details, maintain daily/weekly margin to cover the current open trading position’s profit/loss.
The introduction of fast internet in early 2000’s, made it easy to see live prices and trades in real time. This then enabled the introduction of CFD’s, to retail traders via online trading platforms.
trading CFD: Venue
CFDs are traded over the counter. This means when you place a trade on the online trading platform, the deal is between you and the broker(or market maker for large institutional investors). The broker has DMA(Direct Market Access), however for instance, when trading FTSE 100 CFD on the broker website, the broker does not place the order on an exchange on your behalf. The broker may hedge their aggregated risk(downside) by holding FTSE 100 futures or options on the exchange or book a trade with an investment bank.
trading CFD: Margin
Margin is the amount of cash you are required to maintain with the CFD trading broker, to cover your potential loss. Based on the price you bought the asset, you will either be in profit or loss at any given time-point in the future. The online trading platform will use the current market price to calculate the required margin balance in real time. Many brokers offer a margin lending facility to ensure your CFD trading position is not automatically closed if the actual margin balance drops below the required margin balance.
trading CFD: Leverage
Unlike buying/selling a physical asset, where 1 unit of an asset allows you to speculate on one unit only, CFD brokers allow you to take a trading position at a multiple. For instance when you trade FTSE 100 CFD, you may choose the value of each point movement. This could be anywhere from £0.01 – £50.00. This opens the possibility of making large profits( or large losses) even for a small movement of the asset. You do not need to put up a large amount of capital upfront to gain a large exposure.
trading CFD: Expiry
Unlike trading Futures or Options contracts, CFD (generally*) never expires. CFD trading allows the option of closing the position at any time either manually or via stop loss/stop limit orders. in the current high speed internet age, and 24 hour retail trading environment, brokers quote bid and ask prices for trading stock index CFD, even outside of official stock exchange trading hours.
*check your broker terms
out of Hours Stock Index trading
The prices quoted outside of exchange trading hours, on CFD trading broker sites, are speculative/expectation of next day’s prices. This is because an index value is the weighted sum of mkt capitalisation of it’s constituent companies. And prices of constituent companies’ stock is not publicly available until the next day, when the stock exchange opens.
The bid-ask spreads quoted by brokers, generally, tends to widen during out of hours trading of stock indices. They do this to account for the additional risk of adverse movement at ‘market open’, the next day.
The ‘out of hours’ prices depend on a few factors. For instance market news about constituent companies(new deals, bankruptcy etc.); exchange traded futures and ETF’s prices at other exchanges; and prices of other indices. For example – FTSE 100 out of hours price will take cue from Dow Jones and S&P 500, post close. And from NIKKEI 225, pre-open.
It is important to spend some time learning the history and basics. This time spent will yield dividends when you are trying to predict movement of an asset. Also remember that you are more rational before you place a trade. So, it’s important to set some rules. If you like market conditions and they fit what your rules suggest, go for it. If the conditions for the rules don’t fit what you see in the markets, don’t trade for it’s own sake. You don’t have to trade every day. The point of having rules is to run them to your favour, and not let them run you.
Day trading follows the same rules we use for life. Successful trading is the art of using knowledge and skills at the right time. It is also essential to set some limits once you open a position. For example, you may impose a limit on yourself to not keep a trade open for more than 20 days. Finally get access to good tools that can help you achieve your trading goals. It’s best to try out a lot of things on paper money accounts before risking your capital.
Despite of all the rules, limits and right mindset, random events will happen. So always have a contingency plan. A perfect system or rules don’t exist. And, this is a good thing. Otherwise, someone will work it out and own half of the free world. All algorithms, tools, systems and rules are based on a snapshot of data. So always pay attention to news and data on a given day.
how to trade profitably over the long term
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