CFDs For Dummies (Australian Edition)
Considering trading CFDs? These versatile derivatives offer good potential for higher returns — but with this potential comes higher risk. There are some fundamental aspects you should be aware of before jumping into CFD trading. Manage your risk and plan your trading — take a look at the following points and tips.
The Ten Most Important Things about Trading CFDs
No matter what financial instrument you are trading, you need to plan your trades carefully before putting capital at risk. When you trade CFDs, the leverage component of these derivatives means that you need to be even more careful.
In many ways, the top ten things to consider when trading CFDs relate to risk management and sensible planning. While there are various trading methods that can be developed to help you work out how and why you will place a trade, these tips are fundamental to all successful traders.
Keep your risk levels conservative by using stop losses and sensibly sized positions.
Realise that you aren’t going to make a fortune overnight by using leverage. Instead, try to move yourself forward gradually with a well thought out trading plan.
Pay close attention to managing your existing trades — don’t just look for new trades.
Work hard on building a single trading method that is effective and suitable for you before trying or adding a new one.
If you change your plan, do so step by step instead of all in one go — this way you can much better determine what’s going well and what’s not.
Don’t make your decision about which provider to use based on which one provides the lowest margin requirement — you generally don’t want to be so highly leveraged that this becomes a huge issue.
No matter how experienced you are with other products, start very small with CFD positions so that you don’t face unpleasant surprises.
Be aware of the risk that you’re exposed to — both on individual positions and in your portfolio as a whole.
Leveraged trading shouldn’t make up the majority of your investment portfolio and nor should it be done using money that you need to live on.
Don’t search for the perfect method that will always be correct because it doesn’t exist — instead focus on keeping your losses small and your methods consistent.
Building Your CFD Trading Plan
Once people hear about the benefits of trading CFDs, they often want to get started right away and you may feel the same — you just want to have a go. Resist the temptation, though, and spend some time thinking carefully about how you’re going to approach and manage your CFD trading before you put a cent at risk. When determining your trading plan, there are some important factors to consider, including:
Your method. It is important to develop a method you can replicate again and again. If you trade with little planning you will find it very difficult to work out what happened through luck and what happened through good management.
Your entry points. You need to know what trades you are looking out for and what conditions will trigger an entry into a position. Be sure never to change your reasons for being in a trade after you enter it — once you start doing this you can justify being in any trade because all you need to do is just change the reasons around.
Your exit points. You need to know where you will exit a position and how much you are willing to risk before you actually place the trade. While you can’t always tell exactly where your exit will be (because of market gapping), you should be very clear as to what conditions need to be satisfied for you to close out your trade.
Your record-keeping. You need to be clear about how you will keep track of your trading. Good record-keeping means that when you look back at how you have done you can easily see the things that you may need to change.
Long Trading and Short Trading CFDs
One of the great features of CFDs is that you are able to trade on both the long and the short side of the market. Even if in the early stages of your CFD trading experience you aren’t sure whether you’ll wish to trade on the short side, you should still spend some time learning what it’s all about so your market knowledge is more rounded.
Trading the long side means that you have used a buy order as your opening trade or ‘gone long’. This means that you are anticipating a rise in price and will use a sell order to close your position.
Trading the short side means that you have opened your trade using a sell order or ‘gone short’. This means that you expect prices to fall and will use a buy order to close your position. (This may sound odd but it’s the way you close out your exposure to the market.) The benefit of short trading is that you can profit directly from falling prices, which is very difficult to do without the use of products such as CFDs.
Knowing Your Order Types for CFD Trading
You need to be prepared to take responsibility for the financial market trades that you make, whether they are profitable or not. If you don’t know all your types of orders, though, it’s going to be impossible for you to trade with confidence. Once you do know your order types, you can focus all you time on your trading strategy and execution. CFD providers will generally offer you a wide selection of order types, which enable you to much more easily execute your trading strategies.
A market order enables you to enter at the current price.
A limit order enables you to place an order to buy (or sell) at a lower (or higher) price than the market is currently trading at. Traders may use these types of orders when they are waiting for prices to move close to a support or resistance level before entering the market.
A stop order allows you to close a position below the current market price and is the primary means traders use to manage risk on each position that they take out.
Other order types include if-done orders and one cancels other orders. The types of orders available will depend on the provider that you use, but generally these more advanced orders enable you to link different order types together to execute more of your strategy in one go.
Knowing Details about Your Financial Markets before Trading CFDs
With many CFD providers, you can deal across a number of markets from the same platform. Before entering the different markets available, though, you need to learn about market opening and closing hours, currency impacts and the specifics of the underlying products that you are trading. Check with your provider for the details of the CFDs that they offer and the times at which they are available to trade. Basic points to remember include
CFDs are prices based on the value of an underlying market. This means that you need to know the conditions under which this market operates. For instance, if you wish to trade share CFDs in Canada you will need to know when the underlying share market is open because that will dictate when you can trade the CFDs too.
Foreign exchange trades 24 hours a day between Monday morning (Asian time) to Friday evening (U.S. time).
Many commodities and indices trade very long sessions but may close periodically over the course of 24 hours.
Knowing Your Risk when Trading CFDs
When it comes to leveraged financial trading, managing your risk is paramount. When starting out in trading CFDs, many traders think that knowing their entry and exit signals is the key but this really runs in second place compared to preserving capital — without capital you can’t trade, no matter how good your entry signals are.
When it comes to knowing your risk, there are some important points to remember:
Don’t over-leverage. The amount of leverage you allow yourself should always reflect the amount of capital you have in your trading account — and you should be aiming for about 3× leverage on your capital. For example, if you have $10,000 in your account and hold $30,000 worth of positions, you have applied 3× leverage to your capital. While the leverage that you have applied to an individual position may be much higher, always remember to check the broader picture of your total leverage and keep it under control.
Don’t open too many positions. A lot of people focus their energy on finding the CFD provider that offers the lowest margin requirement but then go crazy opening multiple positions and end up using all their available capital. This is a mistake — because of the effects of leverage, all it takes is one bad trade and your trading capital could be wiped out. Always keep plenty of spare cash available.
Know the conditions under which you will exit a trade before you get in. If you do this, you can work out what a losing trade will cost you before you make the trade.
Don’t assume your exit point will be exactly where you have set your stop loss. To varying degrees, ‘gapping’ can occur in all markets. This means that your stop loss will be executed at a worse price than you anticipated, costing you more — depending on the market, sometimes a lot more.