Many of you reading this will be looking for a way to invest some of your hard-earned cash. Over the years youâ€™ve been able to put a little bit away every month and want to find a way to invest it with the potential to earn you more profit than you currently receive from your friendly local bank. Some of you will consider trading in stocks and shares, but soon realize it requires a little more capital than youâ€™ve managed to save. And there is also the fact that trading stocks and shares requires a certain amount of knowledge. Which is possibly something you havenâ€™t got. That doesnâ€™t mean we think youâ€™re dumb. On the contrary. After all, arenâ€™t you looking for a good way to invest your money? Thereâ€™s nothing stupid about that. There is a way to invest in shares without actually having to own them in the physical sense of the word. CFD share trading is similar but rather than buying the actual share you are buying a contract between yourself and your chosen CFD shares provider. There is also another difference known as leverage. Which is something that allows you to trade on margin and open larger positions than your capital would normally allow. Feeling a little confused? Donâ€™t be, keep reading because weâ€™re about to explain.
What are the differences between buying shares and CFD share trading?
- Rather than owning the actual underlying asset as you would in share trading, CFDs are a contractual agreement you have with your CFD broker. It is an agreement to exchange the cash difference between the opening and closing prices of the contract.
- As opposed to share trading, CFD trading is exempt from UK stamp duty, but your profits will be subject to capital gains tax.
- CFDs are traded on margin. This means you don’t have to pay the full price of the contract out of your own pocket. Instead, you lodge an initial deposit with your CFD broker and it is the broker who provides you with the extra leverage to open bigger positions.
- Trading of CFDs can be long or short, and in the event of a short sale, you do not have to deliver the underlying asset.
Weâ€™ve just mentioned leverage for the second time, so weâ€™d better explain exactly what it means for you. And be prepared because we will also be offering some very important advice.
What is leverage in CFD share trading?
Itâ€™s time to explain the term leverage, as it is one of the main reasons a growing number of ordinary people are choosing to join the CFD trading family. Without it, the ordinary man, or woman, would find trading the markets very restricted. It would require huge amounts of cash, which letâ€™s face, arenâ€™t always that easy to come by. In conventional trading, you would be required to pay a broker the full value of any shares you are wanting to buy. Letâ€™s give you an example. Imagine you want to buy 1,000 Apple shares. The current value of these particular shares is $117.29. The total value of the shares you want to purchase is $117,290. Such a high price will also likely limit your choices to a smaller number of shares and a better choice of companies, or the same amount of shares but only investing in one company. Either way, it goes against the old adage â€œNever put all your eggs in one basketâ€. CFD share trading is the answer because you are able to trade on margin, also known as using leverage. It means you only have to deposit a small amount of the trades total value, but are still able to maintain the same level of exposure. Letâ€™s imagine your CFD share trading broker requires a margin of 10%. This means you will only need to deposit $11,729 plus any commission, in order to trade the same position. Margin requirements or the leverage offered by CFD brokers vary, and the figures will also depend on the underlying asset.
What are the benefits of trading CFD shares on margin?
The biggest benefit of all is the fact you will only have to deposit a small fraction of your trades value but still be able to maintain full exposure. Letâ€™s take the above example. You only need to make an initial deposit of $11,729 plus any commission charges and still be able to maintain a total exposure of $117,290. Imagine the price of Apple shares rises in your favor by 10%. This means you get to make a net profit of $11,729, which is a pretty sizeable return on investment. But we can already hear the cynics among you shouting â€œthat sounds too good to be trueâ€. And sad to say it is. All is not as rosy as it may first appear in the world of margin CFD share trading. Whenever you make any form of investment, but particularly in the world of financial trading, there is the potential to lose part or worse still, all of your investment. Should the market move against you. And if youâ€™re trading on margin, leverage makes it possible for your losses to far outweigh any gains you may already have earned. Say the price of Apple shares goes against you. It could mean your net losses far outweigh your initial deposit. But all is not lost, or it shouldnâ€™t be if youâ€™re sensible and include something we call risk management.
How to reduce the chances of losing it all when trading CFD shares
CFD trading is a risky form of investment, but it is perfectly feasible to keep your losses to a minimum by employing a risk management strategy. Using the best risk management tools will limit your potential losses without impacting on your profits. Letâ€™s give you some examples of what you can do. Make standard stop loss orders With stop loss orders you will be able to reduce risk because a losing trade will be automatically closed once the market value of the asset passes a certain value you will have set. If the market moves against you the trade is closed thereby cutting your losses. This type of order, however, is not completely dependable. The problem is that your order will be closed at the best available price once the stop order had been triggered. Generally, this can happen during times when the market is very volatile. In other words, prices are changing very rapidly and the level at which your trade is closed out could be different than your trigger value and is commonly known as market gapping. Make trailing stops This is another very useful risk management tool to help you keep potential losses to a minimum. A trailing stop is a type of stop order but trails your position by a certain amount, rather than using a specific value. A trailing stop will move along with the market, providing it is moving in your favor. But when it moves against you the trailing stop will be executed. It is possible to have either a sell trailing stop or a buy trailing stop. When the markets are falling a buy trailing stop is the best option. But when it is rising the sell trailing stop will be the better option. There is more flexibility with a trailing stop because it automatically tracks the direction of the marketâ€™s price and doesnâ€™t have to be reset. Which is what is required with a standard stop loss order. A trailing stop is also not a foolproof method because the same problem can happen during times of high market volatility. Make a guaranteed stop loss order This is the most efficient risk management tool and works in a very similar way to standard stop loss orders. The difference is it guarantees to close your trade at the trigger value. Regardless of any market volatility and gapping. There is generally an additional premium which you will have to pay when the order is confirmed. Using CFDs as a hedging tool CFDs let you short sell which is an opportunity to profit from market prices which are falling. For this reason, they are often used by investors as a hedging tool to insure offset losses in a portfolio. Letâ€™s give you an example. Imagine you have a long-term portfolio which you want to keep, but are a little worried there is going to be a short-term risk to your investments value. It is possible to mitigate any short-term loss by hedging your position. Should your portfolio’s value fall any profit you make with the CFDs can be used to offset your losses. Thereby allowing you to keep your portfolio but not suffer too much from any loss to the overall value. We previously mentioned one of the reasons so many new traders are looking at trading CFD shares and other assets as a form of investment. Trading on margin, or using leverage means you can open much larger positions than your capital would normally allow. But there is a big risk with this type of trading, and itâ€™s time to address it.
Understanding the risk of CFD share trading on margin
Many traders find CFD trading attractive because it offers ample opportunity to start trading with very little capital. Unfortunately, many new investors fail to realize the risks involved and simply donâ€™t understand what can happen and how devastating it can be when things go wrong. For this reason, we thought weâ€™d spend some time educating you so you can be better prepared. After all, we want you to enjoy CFD trading and be able to do it safely and preferably not lose all your cash. Leverage is a very powerful tool when it comes to CFD trading, as it requires a relatively small outlay of capital. Rather than having to pay the full value of your CFD contract you are able to enter a position with a margin as low as 5% to 10%. Thereby providing the opportunity of greater exposure than you would otherwise be able to achieve. It is important for you to realize, however, that even though the initial deposit is small it still exposes you to any subsequent price movements of the full value of the position. Letâ€™s imagine you are planning to trade a CFD at 10% margin, which is equal to leveraging your exposure by 10 times. This means that with a $10,000 deposit you will be able to open positions up to $100,000. With such a large amount available it can mean that even the smallest of price fluctuations can result in substantial gains. But you have to remember it also works the other way as well, and any losses will be equally substantial, should the price move against your position. Leverage can sometimes be a difficult concept to understand but itâ€™s important you have a clear understanding before committing any of your funds. After all, it is a double edged sword and is one with the potential to end your trading career very rapidly.
Best CFD Share Trading Brokers
Want to understand the effect of leverage? Think what happens when you buy a house
A comparison you might find useful to help you understand is to imagine yourself buying a house. Itâ€™s highly unlikely you would have enough capital to buy the house outright so you put down a deposit of say 10% or 20% and borrow the rest from a mortgage company or bank. The amount you borrow will be paid back over a number of years. Until fairly recently, when the housing bubble burst, property was considered an extremely safe and profitable form of investment. With the help of a mortgage, you could afford to buy a house worth say $200,000 and only have to make an initial deposit of $20,000, with further monthly payments of $1,000. When the value of your house rose, as it generally did, by say 10%, you would have made $20,000 on your initial $20,000 investment. Youâ€™ve all heard of the housing bubble and it is a good representation of what can happen when trading CFDs. As long as you are making good trades, leverage is a good thing. But, if you make some bad decisions and donâ€™t appreciate the value of good money management, youâ€™ll find yourself in the same position as a number of newcomers to the housing market, who didnâ€™t believe house prices would ever go down. What happens when prices go down is that you end up owing more than you have available. It is called being underwater or upside down on your mortgage in relation to houses. But with CFDs you get wiped out. You can, however, control how much you lose with CFDs because you are able to choose the moment to sell. Unlike real estate, where you have the problem of finding a buyer or you canâ€™t sell because you need somewhere to live. It is also possible to trade CFDs without the assistance of leverage and thereby keep the risk to a bare minimum. But if you want to open positions larger than your capital leverage can be a benefit because your profits could be much greater than your initial outlay. But on the negative side, your losses could be considerably larger than the cash you originally laid out when entering the trade.
How to trade CFD shares safely
In order to trade as safely as possible, it is vital you set a limit. This should be one you are prepared to lose on a trade, and many experts suggest this figure should be set at 2%. This will allow you to work backward so you can see what you should be investing in a particular trade. If youâ€™re not happy with the amount of leverage you are making use of then donâ€™t be afraid to cut back. There are also a number of CFD brokers who give you the opportunity to open mini contracts on certain markets. Which are great if you feel a little anxious about the effect a price movement will have on your profit or loss because youâ€™re just cutting back on the trade size. CFD trading is difficult enough as it is without stressing every time the market moves. Thereâ€™s no denying CFD trading has the potential to be a very profitable investment. It is not, however, the quick money maker many think. There is a certain amount of knowledge and understanding required for such a turbocharged product. And an unfortunate tendency, especially for beginners, to gloss over the small print and not trade sensibly. We will continue to offer you our helpful advice and help you gain the knowledge necessary. Keep us as one of your favorites and donâ€™t be tempted to jump in with both feet, without testing the waters.