How CFD trading works for beginners

With the arrival of the new tax year in April 2024, many of us are keen on growing our money, and trading stocks is a great option. If you’re new to trading, you might have always told yourself, “Trading requires a significant amount of capital, and I don’t have enough.”  Well, this is where CFDs (contracts for differences) come into play.

please note: CFD trading comes with high risk, and on average 73% of retail investors accounts lose money when trading CFDs. 

Example:

if a share of stock is worth £100, you don’t need £100 deposited in the broker to be able to trade. All you need is a percentage of £100.  This percentage is most of the time determined by the trading law of your country and what the broker is willing to offer.

This sounds great, however there is more to this.

Leverage

A key aspect in CFD trading is leverage. Leverage is similar to a loan. Purchasing one stock worth £100 may not offer a huge profit, but what if the brokers lets you trade £10,000? This is where leverage comes to practice.

Leverage is expressed in ration such as 1:50, 1:100, 1:200, 1:250 or 1:500.

Let’s assume you are using a broker that is offering leverage of 1:100 and you have a capital of £10,000. This means you can trade up-to £ 1 000 000.

Margin

If you are trading using CFDs, it is crucial to understand the close relationship between leverage and margin. Unlike traditional stock trading, where you typically need to have the entire value of the stock deposited, CFD trading operates on a margin system.

With margin trading, you’re only required to deposit a percentage of the total position value, known as the margin requirement. For instance, let’s say you want to open a position valued at £100,000 with leverage. Your broker might require you to deposit only 4% of that value as margin, which equates to £4,000.

This means that with just £4,000 as margin, you can control a position worth £100,000, thanks to the leverage provided by your broker. While leverage can amplify potential profits, it also magnifies potential losses, making it essential for traders to manage their risk carefully

How to reduce risks while trading CFD?

Leverages in CFD is very tempting, with this temptation we should be very careful not to get excited and make huge loses. This is why we need to follow few strategies to reduce our loses:

1. Stop-loss is your best friend

Imagine opening a position on Brent Oil and you have conducted analysis. Suddenly, during the trading hours a sudden change happens and this goes completely against your plan. This is where stop-losses come into play. A stop-loss allows you to set a percentage or value amount of money that you are willing to lose.

Example: if you anticipate Gold rising and buy a CFD contract at $2,000, but you don’t want to risk losing more than 10% on the trade, a stop-loss will be helpful. Stop-loss features allows us to set a percentage of loss we are happy to make. When this percentage hits, the broker will automatically close the position thus preventing us from making more losses.

This means that if the gold price drops more than 10%, the position will be closed, resulting in a loss of $200. This feature is advantageous as it helps with our trading plan and can be easily incorporated into our trading strategy.

Demo accounts offered by brokers are great way to explore this feature, you can for instance open positions on renewable stocks using demo accounts.

 

2. Start small

Always start small with trades. Starting small let’s your position losses to be small this offers you more time to analyse your trading strategy. If you are experience continuous losses invest more time in analysing the market. Don’t get excited to increase your position size when you make profits. Patience is key!

3. Keep an eye on your profit/losses

CFD let’s you trade with little deposit. For some early traders they might forget to keep on eye on their losses and they might think they are making profit with few successful trades. Have an excel document that tell’s your overall profit and losses. If you find out that you are making losses on specific market re-think your future positions.