Why trade CFDs?
There are simple ways of using CFD trading to compliment existing share dealing positions, we explain why holding a CFD Account could be an important part of your overall trading strategy below:
Hedging
Trading CFDs is so popular in hedging strategies because CFDs are based on margining, this means you don’t have to put a lot of money down in order to cover a large share position through short selling.
Hedging is used when markets are volatile, traders are uncertain as to the way the market will move and want to reduce the risk of losing any profit they have already made.
Using hedging to cover a single share position is a popular strategy. If traders become uncertain as to where the market is heading they short sell an equal value in CFDs to that of their share trade to offset its value.
That means that if the share price falls, the profit from shorting the CFD balances out the loss from the share trade and the opposite occurs when the share price rises. Whichever movement happens, the profits balance out the loss. Once a trader re-establishes a feel for what the market will do, he either closes the CFD position or sells out of his share position, as the need for hedging disappears.
This means that any profit already made from trading before the hedge was created is retained and the volatile market is ridden out with a good chance that little damage has been done to profit.
Pairs Trading
Another popular CFD trading strategy is Pairs Trading. A trader will invest in CFDs to take advantage of short selling. He chooses two companies in the same sector, buying one and selling the other. The companies are usually chosen by their performance, the stronger one being bought and the weaker one sold.
One of the assumptions of this strategy is that shares from the same sector generally tend to move in the same direction.
If the sector does well, the assumption is that the share price of both companies will increase. The stronger company will hopefully increase at a greater rate in comparison to the weaker company. Profits from the purchase of the shares in the stronger company would serve to offset the losses from the position in the weaker company with the chance of a net gain in addition.
If the sector performs poorly then both companies will find their share price drops. The weaker company’s shares will often drop at a greater rate than the stronger company. Profit would therefore be made from the short sale of the weaker company and would serve to offset the losses from the position on the stronger company with chance of a net gain in addition.
What next?
It is important to fully understand these strategies before using them to invest in CFDs. Using our similator to try them out should help you decide whether use them in real-time CFD trading.
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CFDs
Contracts for Difference are leveraged products which offer a potentially large exposure to the underlying security for a relatively small amount of capital. This will have the effect of magnifying profits or losses, and consequentially carries significant risk.