Although investing is never risk-free, it usually provides more financial advantage than saving. Savings rates are often very low. Many people therefore use the opportunity to start trading online, generating additional income and even building up extra pensions. But of guide there are also people who start investing for fun. Online trading can be very fun and exciting as long as you understand the risks well.
CFD Trading. How does it work and what exactly is it?
Online trading is also referred to as CFD Trading. Investing in CFD’s (Contract For Difference) is relatively new and very popular.
With CFDs you are free to invest in stocks, commodities, currencies and other assets without actual owning the asset you invest in. How does this work?
Trading CFDs means entering into a contract to exchange the difference in price of an asset from the time your position is opened to when it is closed.
This means that CFD trading allows a trader to gain access to the movement in the asset’s price by putting down a small amount of money known as a margin. Unlike with traditional trading you will actually not own the share or stock, but you will predict the price movement of the chosen asset, during a period of time. This means you will be able to make profit based on the difference in opening price of the asset and the closing price when you decide to close the trade yourself.
With CFD trading the trader does not need to have large sums of money. You might ask yourself, why? The answer is simple. CFDs give traders access to ‘leverage’, enabling them to amplify their returns compared with movements in the underlying asset.
What is the leverage in CFD trading?
Traders use leverage to magnify their returns. Leverage trading allows them to increase the size of their trades using a relatively small amount of money. It is one of the main advantages of CFD trading – it makes the markets more accessible to the average person who doesn’t have a ton of spare cash lying around.
Leverage is usually expressed as a ratio. So if your leverage is 5:1, that means you can open and control a $1000 trade with just $200 in your account. So basically you only need $200 from your own money (typically called the ‘margin’).
A simple example: Suppose you want to trade in Facebook. Facebook shares cost $5 a piece. You have $500 to trade with. This means you will be able to buy 100 Facebook shares. Because the broker indicates that on Facebook shares the leverage is 10x, you will be able to invest in 1000 shares. (100×10=1000).
You open the position on the trading platform and during the day you see that Facebook shares are going up. The Facebook shares are now worth $5.50. You close the position at the end of the day and per share you have made 0.50 cents profit. Normally you would have made $50 profit. Since the leverage made it possible for you to buy 10x the amount of shares, your profit is also 10x. So 10x$50 = $500.
As you can see in this simple example, the leverage is your friend and can work for you. The leverage is one of the biggest advantages of CFD trading and is what makes online trading so interesting for novice traders as well as experienced traders.
The downside of leverage trading
While the leverage can work for you, it can also work against you. If leverage trading can be used to magnify profits, be aware that it can also magnify losses. Luckily you can start small and get some experience before you choose for the higher leverages. Moreover, there are ways to protect you from loss and limit you risk while trading. Of guide it is important to keep on mind the risks involved. In the risk management section of this guide we will explain exactly how you practice leverage trading in a safe way.
The good thing is though that, you can never lose more money than you put in. So if you invest $100 in Facebook, using 5x leverage, it’s like you invested $500. But even if Facebook’s share price goes up, you can only lose a maximum of $100. Why? Because your trade is automatically closed when it falls below the actual amount of cash you put in.
This gives you the opportunity to increase the value of your trade without ever running the risk of losing more than your initial investment.