How do CFDs work for beginners?

Beginner traders may find CFD trading to be an appealing option due to the low capital requirements and ability to trade on margin.

For newbies wishing to try their hand in the dynamic world of financial markets, Contracts for Difference (CFDs) offer an exciting opportunity. However, it’s important to understand the basics of a CFD before diving into them. Traders who lack a thorough understanding of CFDs may encounter numerous difficulties, one of which could be substantial financial losses!

Whether you want to generate revenue or are just curious about how CFDs work, this guide for beginners on CFD trading will help you grasp the fundamentals and enable you to trade with confidence and make well-informed decisions.

What are Contracts for Difference (CFDs)?

A buyer and seller enter into a contract for difference (CFD), which requires the buyer to compensate the seller the difference between the asset’s current value and its value at the time of the contract. A variety of underlying assets, including shares, commodities, and foreign exchange, are available as CFDs.

Traders can generate revenue from fluctuations in prices through CFDs even if they do not own the underlying assets. A CFD’s value is determined just by the price difference between the entry and exit points of the trade, rather than by the asset’s underlying value.

No stock, forex, commodity, or futures exchange is used in the process. Instead, it is done through a contract between the client and the broker. The enormous popularity of CFDs over the past ten years has been largely attributed to several major advantages that trading them offers. However, there are always risks involved like with the use of leverage.

How to CFDs work

There are two trades in a CFD. The open position is created by the initial trade and is subsequently closed at a different price by a reverse trade with the CFD provider.

A buy or long position is indicated by the first trade, and a sell is indicated by the second trade, which closes the open position. The closing trade is a buy if the opening trade was a sell or short position.

The price difference between the trader’s opening and closing prices, besides any commission or interest, is the trader’s net profit.

Terms beginners should be aware of when trading CFDs

Margin & Leverage

The entire value of a CFD position is not required to be paid when it is opened. Rather, you make a deposit of 5% or 10% of the total cost of the position. In the end, you are just speculating on the price fluctuations of the underlying asset, you aren’t really purchasing it.

This is referred to as leveraged trading, and your margin is the amount that needs to be deposited into your account.

You have more control over how you allocate your capital when using CFD leverage. You might only need to deposit $10,000 to trade $50,000 worth of Apple CFDs for example, which means you aren’t using up all of your available capital in one transaction.

However, you would calculate your profit and loss using the entire $50,000. Therefore, even though leverage can be a useful tool, you should trade cautiously and pay close attention to your risk management.

Commission & spread

On a CFD market, two prices are always displayed. The buy price is the second, and the sell price is the first. The difference between the 2 is called the spread.

Frequently, all trading expenses for CFDs are included in the spread, saving you money on commissions. On other markets, though, you’ll pay in the form of a commission. On these markets, you’ll see that the spread is significantly smaller.

You will open and close long positions at the buy and sell prices, respectively. Conversely, you can also close at the buy price and open at the sell price when using CFDs. We refer to this as shorting.

Shorting

As we’ve seen, a CFD is essentially an agreement whereby your provider undertakes to compensate you for any gains you make in the market.

As you are not taking control of the market, you have the freedom to open your position with the intention of profiting from upward movements (also known as going long) or downward movements (also known as shorting). If the market has increased when you close your position, this will yield a profit. When you sell CFDs, you go short. Here, you stand to gain if the market declines at the time you close your position.

Say, for instance, that you think the weakness in the world economy will soon cause the price of oil to drop. Selling contracts for difference (CFDs) on Brent crude could help you profit from the bear market. You can exit your position and keep the difference in price if the price of Brent crude drops. You would, however, incur a loss if the price of oil increased instead.

How beginners can start trading CFDs

Understand the difficulties of CFDs

For novices, CFD trading can initially seem overwhelming and complex. You run a serious risk of suffering large losses if you don’t comprehend the fundamentals of CFD trading. Prior to starting your CFD trading career, it is essential to understand concepts like leverage, margin, and the mechanisms of buying and selling contracts.

Select a trusted CFD Broker

This is perhaps the most important step. A reliable and secure CFD trading experience can be achieved by choosing a reputable CFD broker with an easy-to-use platform, reasonable fees, and a strong reputation. Most brokers offer multiple asset classes and a variety of account types, a fast and easy registration process that is beginner-friendly, and fast and reliable funding methods.

Create an account

Once you have selected a reliable broker, proceed with the broker’s account opening instructions. Typically, this entails funding your account, confirming your identity, and providing personal information. Various account types are available to suit your preferences.

Build your trading plan

Examine various trading approaches and choose one that fits your financial objectives and risk tolerance. Trend following, swing trading, and day trading are examples of common strategies.

Beginner’s tips for CFD trading

1. Continue doing what you know

There are a ton of CFD markets from which to choose, so you don’t have to jump right into trading exotic assets for instance.

It’s usually a better idea to start out by selecting a limited number of markets that you are already familiar with. When you feel more confident, you can try expanding your diversification a little bit.

2. Risk no more than what you can afford to lose

When trading, position sizing can be quite helpful. The basic idea is to risk no more than a small portion of your total capital, say 1% or 2%, on each trade.

By keeping your overall expenses low, you can afford to lose some but not much of what you learn from your mistakes.

3. Use stop loss order

Stops, also known as stop-loss orders, automatically close a position if it reaches a predetermined loss, allowing you to manage your risk on any given trade. They free you from having to continuously monitor every open position and help to de-emotionalise trading.

Even the most competent traders will never initiate a position without first attaching a stop. Nevertheless, because they are susceptible to slippage, standard stops do not provide an absolute way to avoid risk.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.