How to trade CFDs
When trading a CFD you are taking a directional view on the underlying market on which a CFD is based. If you are bullish or have the view that the underlying market is going to rise you would buy (go long) the CFD.
Vice versa if you believe the underlying market, lets call it Stock XYZ, is going to fall you would sell (go short) the CFD. It is important to note that the CFD trade is an agreement between the CFD trader and the CFD provider and that as a CFD trader you do not have any rights or interest in the underlying market on which the CFD is based.
When trading CFDs a decision must be made as to the size of the trade to be taken. It is important that the CFD trader understands the terms or specifications of each CFD contract as they can differ across regions and between underlying markets, view the Phillip CFDs terms and conditions. For ASX Share CFDs, 1 CFD is the equivalent value of 1 Share on the underlying stock.
In deciding on trade sizing it is important to also understand that a key feature of CFDs is that they are a leveraged product and traded on margin. The margin is the amount required to control a CFD position. For selected share CFDs the initial margin is as low as 10% indicating the trader requires only 10% of the full value of the CFD contract to take a position.
The effect of leverage is that movements in the underlying market amplify the potential returns and losses achieved on the traders account. It is up to the CFD trader to decide on the size of the trade to be taken and in practice it would be unlikely that trading capital would be leveraged to the maximum levels. A prudent trader sizes their trades according to their own risk parameters and incorporates effective risk and trade management techniques to reduce potential losses and maximise potential profits.
STEP 1: Identify the CFD Trading Opportunity
Client believes XYZ Ltd shares will go up. The resulting trade is to Buy XYZ Share CFDs.
|Contract||CFD Bid||CFD Ask|
Traders employ various methods in identifying a CFD trading opportunity including fundamental and technical analysis. Although a CFD position can be held indefinitely due to the contract rollover feature, CFD traders tend to take a shorter term view with a typical trade ranging from 5-14 days in length. The combination of lower trading costs and leverage tends to see many CFD traders take profit or look to cut losses early in a bid to manage market risk or lock in gains.
STEP 2: Decide on trade size
Trader buys 10000 XYZ CFDs @ 2.26
Trade Value: $22,600
Initial Margin $2,260 (10%)
Due to the leverage component of CFDs trade sizing is typically done with risk management in mind. A CFD trader will generally only enter a position once analysis has been done on the underlying market on which the CFD is based to identify factors such as liquidity, expected volatility, target exit levels for profit and loss and an understanding of how the trade is going to be managed. It is also important to allow for unexpected overnight moves on the underlying such as gap risk on markets that do not trade 24 hours.
STEP 3: Execute CFD Trade and place protective orders
Entry Price: $2.26
Stop Limit: 2.00 on stop limit 1.85
Once the trade details have been identified the trade can be executed via CFD trading platform or via phone through the dealing desk. It is advised due to the leveraged nature of CFDs that protective orders such as stop limit orders are placed at time of entry at a level that is in line with the traders own risk profile.
STEP 4: Manage and Monitor
Once the initial trade has been placed the trader should manage and monitor positions by updating protective orders in attempt to lock in gains or add profit targets where necessary.
STEP 5: Review
Following the trade exit, for profit or loss, many educators would recommend that it is good practice to review the trade in its entirety including the decision making process for comparison against the traders strategy. This is considered an effective way to measure the trading plan and assess the trader’s ability to stick to their trading strategy.