Trading Stocks With CFDs
Hello traders, welcome to the Stock Trading course, and the first module, Introduction to Stocks.
In this lesson, we’re going to learn how trading stocks with CFDs work. This is very important because most of you are going to be trading stocks through CFDs, because you don’t have a large enough account to do it through a stockbroker. Which is fine, because it’s practically the same. But you are going to be using your capital more efficiently.
So, what is a CFD? CFDs are contracts for difference. They provide a flexible and cost-efficient way to trade on price movements of thousands of global financial products. Actually, you can trade CFDs from interest treasuries and commodities to shares. But, we are going to focus on the share trading through CFDs on this lesson.
Trading shares through CFDs is really not that complicated and it’s basically the same as trading the shares by themselves. If you think the price of the stock is going to go up, you buy CFDs. And if you think the price of a stock is going to go down, you sell CFDs.
The profit is the difference between the entry price and the exit price. Hence, contracts for difference. And, of course, the loss can also be the difference between the entry price and the exit price if you close your position at a loss.
Now, margin explained. This is where CFDs become interesting for traders. When you trade stocks through a stockbroker, and you want to buy a hundred shares of Twitter for example, which is trading at the moment at 29.55, you will have to have at least $29,550 in your account for the trade, because you have to put the entire position as margin. Which means that you have to multiply the number of shares, times the price of the stock, to know your position size when you’re trading through a stockbroker. With a CFDs broker, often only a 5% margin is required. So, to enter this trade, you would have to put only $147.75. That’s $29,550 times 5%.
So, this is why trading stocks through CFDs can be very interesting for you traders out there that have a small account, or want to trade with the most cost-efficient vehicle.
So, let’s go through the advantages of trading stocks through CFDs.
First one is you can trade on both rising and falling markets with immediate execution and practically no slippage.
You have an efficient use of your capital through the use of leverage. Which means that if you have enough capital to trade 100 shares of Twitter through a stock broker, you might want to trade it through a CFD broker. Because, that will leave you enough capital to make a few other trades at the same time. So, you are utilizing your money more efficiently.
There are no shorting rules or borrowing stocks whatsoever. There is no day trading requirement. This is one of the greatest advantages to trading CFDs, there is no pattern day trader rule. The pattern day trader rule is an SCC designation for traders who trade the same security, four or more times per day over a five day period. This means that this rule was designed for day traders that make four or more trades in stocks per day. To be able to make as many day trades as you want and not be topped at four per week, you have to have at least $25,000 in equity in your account. And with CFDs, there is no day trade rule or SCC designation.
Now, the risks of trading stocks though CFDs are very clear.
The leverage. When you’re trade CFDs, you may provide a small percentage of your total exposure in the form of margin. However, your potential profit or loss can be much greater. An example is, if you buy $500 worth of a stock through CFDs with a margin rate of 5%, you only need to provide $25 in margin to open the position. This is great, but if the position moves 10% against, you will lose $50, which is double the amount of margin that you provided to open the position in the first place. So you have to be careful when trading CFDs. And you have to be disciplined, not to lose large chunks of your account.
Now, let’s go through an example of a CFD trade. And let’s take Twitter, again at 29.55. And you want to play the long side for the profit, because you have analyzed price action, and you have determined that the price of Twitter is going to go up. You want to buy 1,000 CFDs at a 5% margin. That’s great. This means that your margin requirements are $1,477.50. That’s 5%, times the thousand units, times the cost of the stock at the moment or the stock price. Your prediction was correct and you closed the trade at $30.39, making an 84 cent profit, per trade, per CFD. Your total profit will be $840, because you multiplied your profit per CFD, times the number of CFDs that you purchased. In this case, it’s 84 cents, times 1,000. That gives you an $840 profit, when you put only $1,400 dollars worth of margin.
And the same applies for an incorrect prediction and selling position. This means that if you lose 84 cents per CFD, you will have lost $840. And, the same applies for a short position on a profitable trade and a nonprofitable trade.
But basically, trading stocks through CFDs is the best way to go, if you want to manage your money more efficiently on a daily basis.