CFD trading tips

CFD trading tips
| János Csák János Csák

CFDs are exciting financial instruments that can help you achieve your invesment objectives and give you an opportunity to test your investment skills in exotic markets. However, they don't come without risks. In the following CFD trading tips article we explain why guaranteed stop-loss orders are must-haves and why you should limit your leverage. We only recommend CFD trading to experienced investors, and if you're a rookie, it's an absolute must that you read our CFD trading tips.

CFD trading, in a nutshell is using contracts which you can invest in to make a bet whether a particular financial asset, like an equity or commodity, will increase or decrease in value – without actually investing in the financial asset. For example, when you want to bet on the increase of the oil price, you chose a CFD, which has its price change linked to the price change of a crude oil contract. When the price of the oil increases one percent, the price of the CFD will also increase one percent, so you will gain the price difference of the crude oil. Hence the name: Contract for Difference.

CFDs started out as a type of leveraged equity swap in the 1990s in London, primarily used by hedge funds. In the late 1990s CFDs appeared on the retail market as well, while the 2000s and 2010s saw the first exchange traded and centrally cleared CFDs – so things really picked up. The FCA estimated that the number of UK CFD brokers doubled between 2010-16 and UK clients held £3.5bn in their accounts in total. Of course, the picture is not completely rosy. Because of the risks inherent in these contracts, regulators are increasingly strict with CFD providers. The Australian Exchange closed its CFD exchange in 2014, while in some countries, such as the United States or Belgium, CFD trading is outright banned.

Ok, but some of you might ask, what on earth is a CFD trading? Don't worry, we will let you know.

CFD trading explained

Before we start to list our CFD trading tips, it's important to know what we are talking about. CFDs are derivative products, which mean that their value is derived from the value of another asset or security – to be more precise, the CFD will follow the price movement of the underlying security. For example if you buy an Apple share CFD, then if Apple’s share price goes up, so will your CFD’s value.

In the below example, you can compare the profit/loss effect of a no leverage equity position and a 10 times leverage CFD position. You buy both the equity and the CFD when the underlying price (e.g. Apple share price) is USD 100.

 

CFD-trading-tips-how-leverage-works

 

Differences between direct investments and CFDs

There are four key differences between investing in securities directly and purchasing a CFD.

  1. Potentially lower costs. With a CFD you don’t actually own any Apple shares, which means that your costs may be lower in certain countries (e.g. if you’re a UK investor, you don’t have to pay stamp duty like you would with equity).
  2. You can short. It is a lot easier to “go short” – you can bet that the price of a particular security will go down in value, which otherwise may be tricky or impossible for a retail investor.
  3. Wider, more accessible product range. Because of the derative nature of CFDs, issuers can offer more diverse products since they do not have to pay to access exchange markets, they can offer contracts without owning the asset in question. A CFD's issuer can also decide on the size and thus the price of an option, whereas with retail investors contract sizes are often set very high, making them expensive (e.g. oil). 
  4. Use of leverage. A small investment can already earn you nice and fat returns if you take advantage of the leverage smartly. Say you bought that Apple share CFD for $100 on a 10% margin or 10x leverage (i.e. you only paid $10, the rest of the $100 price is the leverage). If the price goes up to $109 your return will be ($10 + $9) / $10 – 1 = 90%, whilst if you invested in the actual shares, your return would have only been ($100 + $9) / $100 = 9%.

You are right – the last part sounds too good to be true. Well, the bad news are that there is always a catch. Leverage is a delicate thing, it exaggerates your gains as well as your losses, therefore investors should be extra cautious. If instead of going up, the Apple share CFD price went down from $100 to $90, your initial investment of $10 would have been completely wiped out, and your loss would have been -100% not -10%. Some products are available at very low margins, say 2%, which means that a 2% drop in the price of the underlying kills your position.

 

CFD trading is best for you if...

 

cfd-trading-tips-typical-investor

CFDs can be a very effective financial instrument, but if handled carelessly they can also cause serious damages to your portfolio. CFD trading therefore should only be done with caution, keeping in mind that over 80% of people lose money with it.

If you’re interested in our honest view, we’d say that given the potential downside caused by leverage, only experienced investors should use these products, who can also afford to lose some money if the tide turns against them.

There is nothing wrong with experimenting, just make sure you can keep a cool head in case you do lose some money. If you are too reliant on cashing in, you should look for something safer.

CFD trading may be for you if you:

  • Know the pros and cons of CFD investments. Reading our CFD trading tips is a good start, but we strongly recommend extra research and a demo account with a trial period.
  • Want to trade on a short-term basis. If you are a buy and hold guy, you have almost nothing to do with CFDs. These high leverage positions usually need active, daily management and the financing or overnight fees can also bite out a big chunk from your return.
  • Want to hedge your portfolio. You may have long term investments in a different account, but in the short run you think the market might go the other way and you want to make sure you don’t lose out on it. Say you have a stock portfolio, including Apple stocks you bought for $20 a share back in the day. Apple’s price is $100 today, and you believe it will continue going up in the long term, but have a suspicion that over the next month it will fall. Instead of selling the shares in your stock portfolio, you can short Apple share CFDs to hedge your downside.
  • Understand the large investment class. Investing in the large asset class via underlyings can be challenging due to the huge contract sizes (e.g. USD 100k) or difficult to reach exotic markets, like India. With CFDs these are all more accessible, but it also comes with greater risks. It presupposes a level of familiarity, so if you don't know anything about bitcoin then you shouldn't buy a bitcoin CFD either.
  • Want to go short. CFD investing enables you to test your opinions – whether you think that a market / security will rise OR fall. I.e. you can bet that the price of an asset will go down and cash in if it does. It might feel strange at first to sell something you don't own, but theoretically this makes markets more efficient.
  • Want to trade on leverage. It helps you multiply your gains by only requiring a fraction (the margin) of your investment upfront, but the rest of the price is something like a loan. You will have to pay for it regardless of your investment's performance.

 

Step-by-step guide to CFD trading

 

The investment process

CFD trading works pretty much like any other investment.

  1. Before getting into CFD trading, try a demo account. See if you can do well in a safe environment, and don’t assume your performance will be any better with real money.
  2. You start by opening an account. This should be relatively straightforward if you already did some investing before – and if you didn't, CFDs shouldn’t be where you start anyway. In another article, we have selected a list of brokers who we think are the best CFD brokers and have the best trading platforms in Europe.
  3. Fund your account, but don’t put your life savings in it. Start small – and we really mean small! – and keep in mind that you are using leverage, so you don’t necessarily need that much money anyway.
  4. Choose your asset and set the leverage. Again, if you want to hear one of our best CFD trading tips: you don’t have to max out on leverage. Make sure you did your research and you are not placing an order just because your mate Jimmy swore it was the deal of the century. Unsurprisingly, the FCA is planning to put a minimum limit on margin requirements as part of their CFD trading regulations.
  5. Place your order by choosing your order type and term. We cannot overemphasise the importance of using (guaranteed) stop-loss orders. This is absolutely crucial. Later we will talk about the differences between stop-loss and guaranteed stop-loss, and in our leverage example you can also see why it is vital that you use this option.

    cfd-trading-tips-order
  6. Once your order is executed, don’t forget to review and monitor your investments regularly. As we will point out later, you shouldn’t put all your eggs in one basket. Think about your investments as a portfolio, in which some investments will gain and some will lose value. You can reduce overall losses via diversification and harness your gains before they disappear. 

 

Having a wider investment universe - CFD types and available markets

 

Available markets and asset types

cfd-trading-tips-products

A good thing about CFDs is that you have a wide range of opportunities to invest in. You essentially can choose any market or asset class, chances are that you will find CFD trading opportunities for each. Just to name a few:

  • Stocks
  • Indices
  • Forex
  • Commodities (metals, energy and beyond)
  • Bonds
  • Options

Similarly, the available markets are also quite varied, e.g. a European investor can invest all over the world from Canadian stocks to Asian indices. If you wish to trade in forex, you can access currency pairs beyond the usual suspects: emerging currencies, as well as even more exotic contracts, such as bitcoin are available.

 

Exchange traded vs. OTC

CFDs are mostly over-the-counter (OTC), i.e. you enter into a personalised contract with your broker. This option is more widely available, however, it also has its own shortcomings, such as counterparty risk and lack of transparency regarding spreads.

The other option is using exchange traded CFDs, which you can access via Direct Market Access (DMA) trades. This means that you’re trading on an exchange similar to equity exchanges, hence the pricing of the CFDs is market driven, and not defined by the brokerage firm you’re dealing with.

 

Cash index CFDs vs. index futures CFDs

Some providers, such as IG, offer cash index CFDs and index futures CFDs. Cash index CFDs have no expiration, while index futures CFDs have an expiry date.

 

CFD trading is not cheap

 

You can come across two types of trading fees: commissions and implicit trading costs in the form of spreads. Other non-trading fees (financing fee or inactivity fee, etc.) may also apply.

One thing that we would highlight of these non-trading fees is the financing fee. If you keep your CFD contracts open overnight, you’ll be charged an extra fee. This is a basically the cost of leverage, since at the end of the day you are borrowing money from your broker by using the leverage.

Given the financing costs, these contracts may not suitable for buy and hold type of strategies, so if you’d like to invest for the long term, think about other asset classes first.

 

Cost of transaction

Interactive Brokers

IG

Saxo Bank

Swissquote

eToro

Oanda

Degiro

Typical CFD charges for an EUR USD forex trade charges

0.2bp plus spread (see cell below)

Spread only (see cell below)

Futures market spread + fixed markup (2pips)

n/a 

3pips

Spread only (see cell below)

n/a

Typical spread for an EUR USD forex trade Can be as low as 0.1pip (plus commission) 0.75pips (CFD trading only) Can be as low as 0.2pip (plus commission depending on trading volume) 2.8pips 3pips (CFD only) Varies (around 1.1-1.3pips) Commission based (either EUR10.00 + 0.02% or 0.10%)

Financing fee

Benchmark rate +1.5%

2.5% over the interbank rate

Min. 8%

Depends on the currency (EUR: 3%)

Depends on the traded product, e.g. 5.2% for long Apple 

Depends on the currency (EUR: 0.4%)

Depends on the currency (EUR: EONIA + 1.25%)

Our recommended CFD brokers

 

If you choose to try our CFD trading tips yourself, you need to find the best CFD brokers to use. You can read about the best CFD brokers in 2017 on our blog to find out which brokers are the best for CFD trading. We have also prepared a list of brokers that offer CFD investments for you.

The first four brokers (Interactive Brokers, IG, Saxo Bank and Swissquote) below are considered to be the safest, because they either have a bank parent or they are exchange listed.

  • CFD-trading-tips-interactive-brokers Interactive Brokers – one of the largest US brokers with very competitive fees. The CFD product range is not extensive and the user experience is relatively limited.
  • CFD-trading-tips-IG IG – UK CFD specialist, considered to be the market leader in CFD trading. Its product range is really wide and includes share, index, forex, commodity, option and bond CFDs.
  • CFD-trading-tips-saxo-bank Saxo Bank – Danish investment bank with strong proprietary research. The pricing is relatively competitive, though not the best, but their platform is great.
  • CFD-trading-tips-swissquote Swissquote – leading Swiss online broker with limited CFD product offering. It has a nice trading platform and good research, however.
  • CFD-trading-tips-eToro eToro – Israeli social trading site with a straightforward platform. We recommend it to you if you want to follow and copy someone else’s investments.
  • CFD-trading-tips-Oanda Oanda – independent US broker with a big emphasis on client satisfaction. Recommended for traders with a forex focus.
  • CFD-trading-tips-DEGIRO Degiro – Dutch discount broker with an easy-to-use platform, competitive fees and a good product range.

11 CFD trading tips

 

There’s no secret sauce to investing, so you shouldn’t expect our CFD trading tips to make you a billionaire in two weeks. Anyone who promises that is a fraud and you shouldn’t touch them with a barge-pole. (And also: if we had the secret sauce we would be sipping a cocktail on our yacht somewhere warm.)

 

  1. Use stop-loss orders. Rule #1: use stop-loss orders. Rule #2: use stop-loss orders. Rule #3: use stop-loss orders. If you want to hear our single most useful CFD trading tip, it’s this: make sure you limit your downside by using stop-loss orders, or even guaranteed stop-loss orders. We strongly recommend the guaranteed stop loss order because with a regular stop-loss order even if the asset price reaches the stop price, the sale of your asset may only be executed at a price below your stop price. In the case of a guaranteed stop loss order, however, your broker guarantees that you will get your stop price, no matter what. So say you buy an Apple share at $100, with a stop price of $85. If, for some reason, Apple’s share price suddenly falls to $79, with a regular stop-loss order your CFD may only be sold when the share price hits $79. With a guaranteed stop-loss order, your broker will make up for the difference, so you will get $85, even if the sale happened at $79. It’s not for free, but it is something worth paying for. When you’re in doubt, think about the effect of leverage on your investment when it goes the wrong way.
     
  2. Use a demo account first. Before you jump into it, we also recommend that you begin your CFD trading career with a demo account, which will be offered by most providers. So if you want to test our CFD trading tips free of charge before risking actual money, it’s a good start. Try it to see if it’s for you.
     
  3. Do your homework. Understand what you do, both in terms of CFD trading basics as well as your particular investment. So don’t start investing before you know what a limit and what a market order is, don’t trade with forex CFDs before you understand the difference between a USD/GBP and a GBP/USD quote. Also don’t expect that you can be a specialist in all asset classes or in all markets. Choose a small number of specializations and stick with them.
     
  4. Limit leverage. You can use leverage, but when you have the option, consider scaling down on leverage to a level that is acceptable to risk tolerance profile.
     
  5. Do your own analyses. Your neighbor, Wilma, is bragging about how much she made on Bitcoin trading. That doesn’t mean she can repeat her performance – and it certainly doesn’t mean that you should jump right in and start trading Bitcoins like your life depends on it. First things first: read research reports, look up articles on the topic, and do your own analyses, fundamental, technical, or even both.

    cfd-trading-tips-technical-analysis
     
  6. Also make sure that you have a fully aligned strategy: if you’re trading longer term you should be willing to accept a higher level of volatility and vice versa: if you’re looking to score in the short term, don’t set your stop-loss price too low.
     
  7. Be disciplined. Make sure that you don’t start running after your losses and are committed to a disciplined strategy. You make the worst mistakes when you get emotional and start running after your money. DON’T-DO-THAT. Set out your rules and stick to them. For instance if you decide that you will set your stop losses 10% below purchase price, then don’t deviate from your plan just because you’re a massive fan of Apple and “you’re certain it will do well”.
  8. Make the leverage work for you. By using higher leverage you can invest more than you have. This is a nice feature but it requires a responsible approach. Remember the 2008 financial crisis that started out by people taking too big mortgages? Mortgage in itself is a nice instrument, you can buy your house or flat before you have the money for it. But you should only take a mortgage if you can repay it. Otherwise, you will lose your house. CFD trading requires the same reasonable approach.
     
  9. Expect a rainy day. There will be days when your investments will go against you, so always keep enough equity in your account to be sure you can make good on any potential margin calls.
     
  10. Don’t put all your eggs in one basket. CFD investing can help you reach a wide variety of markets and assets, so there’s ample opportunity to diversify – which you totally should. So just because you think oil stocks are the next big thing, don’t go long in Exxon, Shell and BP plus in crude oil at the same time. If you happen to be wrong, you’ll be wrong big time because of leverage already, you don’t need to make it worse by doubling down on it. And in a wider context: don’t rely on making earnings from this source. CFD trading can result in really volatile returns, make sure this is not your only source of income.
     
  11. Think scenarios. Think about potential scenarios of how your investment may perform. What happens when the underlying price goes up by 5%? What if it goes down by 5%? 10%? 50%? You can even prepare a table like our leverage table.

Avoid scams and be careful with leverage

 

CFD trading is a risky business. And we don’t mean the sort of business Tom Cruise ran in his classic 1983 movie. In the FCA’s consultation paper, published in December 2016, the UK regulator estimated that c.80% of CFD investors lost money. Yes, less than 1 in 5 persons made a profit on these investments. You may be that one lucky guy or gal, but be realistic. You are a lot more likely to make losses than to make gains. Besides relying on our CFD trading tips, listed above, you should also be aware of the following pitfalls.

cfd-trading-tips-risks-and-pitfalls

  • Leverage. Leverage is one of the killers here. It works as a multiplier on your investments, both when they go up – and when they go down. And going down they will. Let’s assume you invest in the Apple stock with a $100 price and 10% margin (i.e. your initial investment is $10). Below are some of the outcomes you could see:

 

Apple stock price

Change in price %

Your CFD profit / (loss) ($)*

Your CFD profit / (loss) (%)*

Minimum extra cash you need to pay in when you receive a margin call($)*

$25

-75%

($75)

(750%)

($65)

$50

-50%

($50)

(500%)

($40)

$90

-10%

($10)

(100%)

$0

$100

0%

$0

0%

n.a.

$110

10%

$10

100%

n.a.

$150

50%

$50

500%

n.a.

$175

75%

$75

750%

n.a.

* This is why you should use guaranteed stop-loss orders. The table above represents a range of scenarios when you invest without stop-loss orders.

 

  • No floor to your losses. You can lose more than you have on your account without negative account protection. In a big market turmoil, your margin trading account can go into negative. This is a really scary scenario since your broker can go after your money, which means you can lose more than you initially invested. You are even responsible for your losses with all of your belongings, like your flat or car. Such a shocking case was the CHF crisis occurred when the Swiss National Bank stopped keeping the CHF down in value. In this specific case, several brokers decided not to go after their money, but others are still fighting on courts with their clients. We highly recommend using brokers with negative account protection, and please, only use recommended CFD brokers.
     
  • Counterparty risk. When you trade over-the-counter, you have a contract with another person / institution (your counterpart) about a future transaction. When you enter into a contract like this, there’s always a risk that your counterparty will not honor the agreement and when you made the trade of your life and want to cash in your $1 million return on your $100 investment (don’t be absurd, these things never happen…), your broker will say, “Sorry mate, good on you, but I went bust in the meantime, good luck chasing your money”. We select the good guys (see our broker comparison table), whether you’re looking for CFD or and other online brokers.
     
  • Fraud and scams. One of the reasons we started Brokerchooser was to help you “distinguish between rouge and real”. We are pretty sure you have already been targeted with aggressive popup ads promising easy life and a yacht with two hours of online trading a week. Just stating the obvious, all of these ads come from scam brokers or let’s call them just scam, since they don’t have to do anything with brokerage. There are tons of scams out there so make sure you only use reliable brokers. Our broker reviews are there to help you.
     
  • No guarantee for your stop-loss. If you place a stop-loss order, bear in mind that there’s no guarantee your order will be executed at your stop-loss price. Some brokers offer guaranteed stop-loss orders for a premium, which will resolve this issue – this is, we think, a must.
     
  • Non-transparent spread pricing. You can’t make sense of the pricing of CFDs? You’re not alone. It’s absolutely non-transparent and brokers don’t seem to be as bothered about this as we are.
     
  • Margin call. This shouldn’t happen to you. Margin call means that your investment fell and the money on your account is not enough to make good on your losses so you’ll need to send in some extra money. Back to our dull Apple example: you bought an Apple CFD for $100 on $10 margin. Some bad news hit the market and the price of your CFD falls by $20 down to $80, meaning that your balance is $10 margin less the $20 loss, i.e. negative $10. It’s your investment, you’ll have to make good on this loss.
     
  • Slippage. Executing trades takes some time – an even if it’s not a long time, it’s long enough for some prices to move. Slippage means that the order is executed at a different price than what you saw when you placed the order (i.e. your decision price). Say you have $100 in your account and you placed four trades around the same time, each requiring $25 margin. In some cases the price may move up before your order is executed and now the margin on your first trade is $26 not $25, meaning that you cannot execute all your trades.

Check how you're protected

 

What happens when you trade with CFDs issued by your broker and the broker becomes insolvent? Though it's not directly related to CFD trading tips, it's important to ask the question: will you be covered by the national investor protection schemes, like UK’s FSCS (Financial Services Compensation Scheme)? The good news here is yes, you will be protected. The protection naturally applies for the exchange traded CFDs as well.

The global CFD trading regulation is quite fragmented. In general, you can do it in Europe, while the rest of the world is mixed. For example, CFDs are banned in the US, while allowed in Canada. In Europe, Belgium is the only country where you cannot trade with CFDs. For a full worldwide picture about CFD coverage check Finance Magnates’s article.

In Europe the regulation is clearly in a tightening trend. In recent months some large European countries’ regulators have started tightening their grip on this industry:

  • FCA, the UK watchdog proposed to increase minimum margin requirements on CFD investments, especially for inexperienced traders, and to curb bonuses for signing up.
     
  • BaFin, the German regulator plans to limit CFD providers from offering CFDs that can have larger losses than the initial margin posted.
     
  • AMF, the French regulator requires guaranteed stop losses and negative balance protection options.
     
  • The Cypriot regulator, CySEC has also started questioning how CFD providers operated.

 

cfd-trading-tips-regulation

CFD trading tips - Bottom line

CFDs are exotic animals in the world of investments, and only well-prepared investors should try to hunt them down. Our CFD trading tips are a good start, but make sure you do your homework. Learning by doing is often a good way to approach things, but losing your life savings just to learn how not to trade CFDs is not a good tradeoff.

So last few words: limit your losses, keep your head cool, and don’t go overboard. Investing can be a great experience, and you can enter into markets which you otherwise couldn’t.

CFD investing is a hot topic of European regulators and we think that this is certainly an area which could benefit from a bit stronger scrutiny. We’re excited to see where things go from here.

 


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