How to trade CFDs 101
As you probably know, there are a lot of things you need to learn before actually proceeding in engaging a trade. So, let’s just assume you have already done your homework and have good knowledge of the basics of the CFD trading. If not, feel free to browse my other articles to update your knowledge book.
But if you did, then it means you are somewhat ready of understanding the following examples.
A long position trade (you decide to buy shares, as you expect them to increase in value over a given timeframe)
You decide to take on Asda, the famous UK retail supermarket you have had your eyes on for quite a long while. One major representative of the business announces a massive partnership with E-bay. I know, this is a hypothetical scenario, bear with me. In this case, we have 1 educated course of action, with 2 potential opposite outcomes. Because we are dealing with CFDs, remember? So, the educated course of action is:
In this case, you have the following data:
- One Asda CFD share is worth 250 pence (£2,50)
- You buy 10,000 shares, totaling £25,000
- The deposit you are required to have to maintain a £25,000 position is 10%, totaling £2,500
- You will pay a commission of 0.1% for opening your trading position, totaling £25
Closing the trade on profit
- At the moment of the closure, one Asda CFD share is now worth 275 pence (£2,75)
- You sell all your 10,000 shares, totaling £27,500, at which moment your raw profit is £2,500 (the difference between the share’s value when the market closed and the one when it first opened)
- You will pay a commission of 0.1% for closing your trading position, totaling £27,5
- What you will be left with is £2,472. This is the return profit you are getting. You already have the £2,500 in your account, which you were required to have in order to control a £25,000 position. Those didn’t go anywhere. Now, on top of that, you get £2,472 extra, as a return profit after the trade closed. This is a return rate of 99.8%. You have doubled your money with one simple trick. And trading beginners now hate you. Good job!
But, let’s say something happens and the partnership gets canceled for some reason. You leave your position open overnight and you notice the apocalypse first thing in the morning. Not enough time had passed to allow you to record legendary losses, but a certain damage exists nonetheless. So:
Closing the trade on loss
- At the moment of the closure, one Asda CFD share is now worth 235 pence (£2,35)
- You sell all your 10,000 shares, totaling £23,000
- You will pay a commission of 0.1% for closing your trading position, totaling £23,5
- Your account will now show a loss of £1,500. Let’s break down the facts. You had £2,500 as a margin, used to leverage a position of £25,000. The position crashed by 15 pence per share, at which moment your account registered a loss based on the initial position you had. So, now we have £25,000 minus £23,500 (the assets’ value at the trade closure) equals £1,500. So, your account will now have £1,000 left.
And this is all without calculating other commissions and fees that may come into play. It is quite easy, if you ask me, and I am sure you don’t think it is complicated either. However, here is what I would like you to know and be careful about, in this particular case. I am talking about the precise reasonings you need to go through.
– Are the news legit? – If they are not, you may be in for a bust. Sure, a high-position representative has announced a major partnership. When is the deal set to take place? Are there any words from the other camp? Are there any news confirming this rumor? Never go blind into the action. Or, in this case, one-eyed, because you do have something to work with, after all.
– Have the shares begun to rise following the statement? – As soon as you hear the news, start digging. Most markets will start burning even at the whiff of a rumor, not to mention rock solid proofs. Check the company’s shares and see how they move. If you notice an explosive trend, go for it immediately. It doesn’t even matter if the news are fake. Go for it and keep a close eye on your position. As soon as you get some profit, close it and go home. Instant win.
– You need a stop loss order – I don’t care how verified the news is, or how sure of the outcome you are. It simply isn’t worth it to lose so much money. If you take a look at the “Closing the trade on loss” section, you will only see a £1,500 loss on a £25,000 starting margin. This is an extremely fortunate outcome, because, due to the use of the leverage, your losses have the potential of reaching 600-700% or more. Keep that in mind.
These advices go the same for the rest of the examples as well.
A short position trade (You decide to sell shares as you expect them to decrease in value, over a given timeframe).
Facebook on the line. Several anonymous statements come out, announcing the company’s involvement in supporting Islamic terrorist propaganda and allowing such Facebook accounts to spread related content on its platform. Another hypothetical scenario.
What you now have is:
- One Facebook CFD share is worth 550 pence (£5,50)
- You sell 1,000 shares, totalling £5,500, with the prospect that the shares will drop in value
- The short position doesn’t work on leverage, but you still have to have a margin deposit in place, this time going up to 150% of the amount you are selling the shares for, so £7,750. The margin, in this case, however, has no role to play, because, with short sale trades there is no leverage involved. You sell CFDs and you get back the same amount of CFDs and you get to keep the money.
- You will pay a commission of 0.1% for opening your trading position, totalling £5,5
Closing the trade on profit
- The Facebook CFD drops as expected and the share is now worth 450 pence (£4,5)
- You buy 1,000 shares again, spending £450, to control a £4,500 position, and close the trade
- Let’s do the math. You sold £5,500 worth of shares, waited for the market to do its thing and move towards the direction you have predicted, then bought the same amount of shares, this time for £4,500. The result is that you now have the same amount of shares you had before, plus a profit of £1,000.
It is an extremely effective and simple system and it pays off big time if applied to some highly volatile situations, where the company’s shares move into your direction by a significant and accelerated rate.
But let’s consider that all the rumors about Facebook turn out to be false fast enough to only affect the company for an extremely short period of time. In this case, you will sell your shares, without knowing what is about to hit you. And we have:
Closing the trade on loss
- The Facebook CFDs drop as expected, but only by a limited amount. Then the market decides that Facebook is actually trustworthy and the shares start gaining value. The share reaches 600 pence (£6).
- You see the market going against you, you corroborate that trend with the recent exoneration, so you make the decision to close the position, which can be done by purchasing the 1,000 shares back, for which, this time, you pay £6,000.
- Should we do the math, or is the result obvious enough? You sold the shares for £5,500 and bought them for £6,000. This shows you are now £500 in the hole.
This time we have Apple. A news article comes out, accusing Apple of releasing a new, innovative tablet that will feature the most potent processing power on the market. You see the online environment roaring and the news piling up.
The data you will get is:
- One Apple CFD share is worth 400 pence (£4)
- You buy 10,000 shares, totaling £40,000
- Again, you need to maintain a £40,000 position, which means your margin account needs to contain 10% of the position, totalling £4,000
- The 0.1% commission applies, leading to a £40 minus
Closing the trade on profit
- The market grows and the Apple share reaches 500 pence (£5)
- You sell the 10,000 shares, getting £50,000 in return
- You already know the answer, am I right? The difference between the share’s starting price and the closing one is £10,000. Minus the £40, we get £9,960. With a starting margin of £4,000 and a net profit of £9,960, we can conclude a staggering profit increase of 249%.
But, as you already know the drill, let’s assume the new device gets canceled due to unexpected costs of sudden software faults. What is more important is that another major competitor announces the release of a new device, seemingly operating with the same technology. Apple seems to have been beaten. As a result:
Closing the market on loss
- The market immediately takes action and the shares drop to 300 pence in an instant (£3)
- You sell the 10,000 shares to close the trade and get £30,000 in return as leveraged position
- Can you spot the difference? The assets’ initial price of £40,000 has now become £30,000, leading you to receive a £10,000 blow.
- Remember that 249% profit rate? This time you have the same rate, but on the negative side.
What have you learned?
These trading examples in CFD are meant for one purpose: helping you understand how the market works and how it can turn on you in the blink of an eye. You will not hear this from a lot of brokers, but leverage is a hell of a danger.
Leverage is great as means to increase your profit more than you could have ever dreamed of, but absolutely horrifying when going to wrong way. Your losses could be potentially unlimited. And what I have tried to show you with the help of these examples is that there are plenty of risks you need to be aware of.
Can you avoid them, or, at least, keep them at bay for as much as you can? Yes. Here is how:
1. Don’t take the market for granted
With CFD trading, the market will always work in your favor when you link it to major economic or financial worldwide events. In the sense that you can easily identify the trend or the direction it is heading. But, as these examples are showing, even major economic news can turn the other way quite rapidly.
Maybe we have some unverified news that sends shivers in a certain sector, that end up being exposed as fake. Or some rumors that could turn true, with intense immediate effects. These sudden swings will ultimately reflect onto your investment. Be very careful how you take them, even when they appear to be rock-solid.
2. Don’t invest too much, even if the trade is safe
As specified at point 1, the market might appear safe at one moment, and can go the opposite direction at the next. It is always better to win less and risk losing less, than to win more and risk losing more, as long as you don’t have too much capital to work with anyway.
It may be feasible for experienced traders, with a lot of capital in hand, to go for higher risks, but not for you.
3. Close your position as soon as you see it stalling
Let me explain. If you have bought 1,000 shares on Facebook, basing your choice on the news regarding the company’s implication in terrorist propaganda and you see the shares falling, you immediately sell all 1,000 of them, expecting them to fall even more.
And they do, but then they soon reach one point where they stall. It is here where you need to start worrying. I will tell you why. Because the news that Facebook is indulging Islamic terrorist propaganda is massive. The shares shouldn’t stall after only dropping by a little. If they do, this might show a tendency of rising again.
At which point you need to buy as fast as you can, even though the profit is not too high. At least you won’t lose money.
So, as you see, these CFD examples are only a sample of what the trading market has in store for you. And I know it takes a lot of experience and gut-feeling to sense the market’s movements, but it can be done. All you need is to train your market feeling and work on understanding how it all comes together.
Feel free to experiment with software trading demos to help you improve your game. And always play it safe.