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CFDs have gained popularity in recent years due to the benefits that they offer traders. But CFD trading has certain risks too. We’ve compiled 10 golden rules of CFD trading that can help you to understand the product better.
Before you start trading it is vital that you understand what CFDs are and how they work.
CFD stands for contracts for difference – a derivative product that enables you to speculate on a range of global markets such as forex, commodities, indices and shares, without having to own the underlying asset. This means that you can take a position on rising and falling markets – you would go short (sell) if you predict the price will fall or go long (buy) if you predict the price will rise.
CFDs are a leveraged product, which means that you can gain access to a position by putting down a small deposit, known as a margin. Your profit and loss are calculated on the full size of your position – so it’s important to remember that while leverage can magnify profits, it can also lead to magnified losses, including losses that exceed deposits for individual positions.
Learn more about what CFDs are and how to use them
Continuing to develop knowledge is an essential component of successful trading, which includes knowledge about yourself and your trading goals.
A trading plan provides you with a clear path on how, what, when and why you should trade. It will help to shape your behaviour and avoid the pitfall of making decisions based on emotions. These are the most important aspects that should be covered in your trading plan:
Each trading plan should be unique to the individual. Although your plan can be based on someone else’s, you should always adapt it to your own aims and risk appetite.
A trading strategy outlines the style of trading you intend to use, including a methodology for entering and exiting trades, as well as the tools and indicators that you might use. Your strategy will depend on how much time you want to spend monitoring the markets. There are a range of different trading styles that you can use depending on which strategy appeals to you – including day trading, swing trading and scalping.
Discover these trading strategies and learn how to become a trader
It is absolutely crucial to stick to your CFD trading strategy, as trading based on the parameters you have set will minimise the impulse to trade out of fear or greed. It is equally important to know when your trading strategy is not working. This can be achieved by keeping a record of your winning and losing trades, and back-testing your trading strategy.
When you are building your CFD trading strategy, you need to decide what type of analysis you will use to identify entry and exit points in the market. There are two types of analysis that traders use: technical and fundamental. Fundamental analysis focuses on external events and influences such as macroeconomic data, company announcements and breaking news. While technical analysis attempts to predict the future direction of a market by analysing historical price charts.
Although you can use each form of analysis individually, it is common to use a combination of the two.
Your position size is the total market exposure of your trade. When opening a new position, you should take into consideration your available capital and the amount of risk you are willing to take.
Every CFD trader should outline exactly how much capital they are willing to risk on each trade in their trading plan – and remember this is how much money you can stand to lose.
Remember, CFD trading is leveraged, so your total position size will always be significantly more than your initial deposit, and you could lose more than you commit to a single trade. As a result, a common approach is to only risk a small percentage of your capital on a single trade, and to manage your risk with stops and limits.
A common method of managing risk is attaching stops and limits to a position. These pre-define the exit levels for your trade and can help protect your capital. A stop-loss order is an instruction to your broker to close your trade at a price that is less favourable than the current market price. You need to ask yourself: ‘how much money am I prepared to lose before I close my trade?’ and set your stop-loss accordingly.
You can also place a limit close order, which closes at a level that is more favourable than the current market price. This closes your trade after you have achieved a certain amount of profit, with the intention of protecting your capital from adverse market movements.
Discover the types of orders
As you embark on your CFD trading journey, start small. There are thousands of markets to choose from, so it is important to focus on markets that you are already familiar with or have an interest in. Once you have more confidence in your strategy you can begin to diversify your exposure across a range of asset classes.
CFDs are a great tool for expanding your trading horizons, as they enable you to gain access to declining markets as well as rising ones.
Even though you may have stops and limits in place, it is important to frequently review your positions. This will help you to identify any issues or opportunities quickly and prompt you to act when necessary.
It is also important to make sure that you have sufficient capital in your account to cover the total maintenance margin required to keep your position open. If your account falls below the minimum level of funds, you will be placed on margin call – which could result in your position being closed if you do not top up your account.
A great way of monitoring your positions on the go is to download a trading app. With IG, you can access a range of trading apps specifically designed for mobile and tablet devices, and get price alerts sent directly to you whenever there is a significant market movement.
A successful CFD trader will know that no matter how experienced you may be, you will always experience losses. What makes a trader successful is how they respond to these losses. The rule here is to remain focused and in alignment with your trading strategy by not acting on greed. You will learn over time when it is time to cut your losses, and get out of a losing trade.
If you don’t feel ready to trade on live markets, a great way of testing your trading plan is to open a demo account and practise executing trades with virtual funds. A demo account gives you the opportunity to experience live markets in a risk-free environment, at no cost.
During your time exploring the demo account, make sure that you gain an understanding of the financial terms used and the markets that you have access to. If there is anything you do not understand, you can use trading courses – like those offered through IG Academy – to build a stronger foundation of knowledge on CFDs.
While there are risks associated with trading CFDs, committing time to building your knowledge can give you a significant advantage and reduce your risk.
As we have discovered, finding your perfect trading strategy is an ongoing process that should be tailor made to fit your personality and trading goals. There is no end to your development, as even the most experienced traders can learn more. But if you follow these golden rules and stick to your CFD trading strategy, you will be well on you way to becoming a successful CFD trader.
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