Understanding CFD Trading - Part 2

Submitted by George Polizogo... on 18 February, 2006 - 19:52

CFDs are a lucrative vehicle for professional market traders to leverage their short and long positions.

In Part 1: Understanding CFD Trading we had a look at some basic mechanics of CFDs – Contracts For Difference such as the leverage they offer and how they generally work and fit into your trading toolbox. In Part two we continue in our venture in looking at further intricacies in trading using CFDs.

The main reasons you would want to use CFDs in your trading arsenal is that they offer leverage and this offers two benefits: If you are cash strapped, or capital poor, CFDs allow you to leverage your position and expose your trades to larger amounts; or if you are capital rich you can free up some capital to use in other investments or you have the choice to limit the amount of float in play as part of a risk management strategy. Another compelling reason to use CFDs is the ability to easily short stocks. Of course the advantage here is that you can make money on a bearish stock or market. Finally you can also use CFD’s to hedge your position or portfolio – an alternative to using options. Here are some other CFD Trading Strategies you may want to look into

Although we went through the gearing lecture in Part 1, there was a few pieces of jargon that I forgot to mention. In the previous example we used $100 to buy $1000 worth of shares. Which means there is a 10% margin or deposit. Some dealers may also refer to this as a 10:1 leverage. If you are mathematically gifted this would have been a "given". Comparatively, forex dealers have a 100:1 leverage, which means as a trader you only fork over 1 per cent.

Another feature CFD dealers offer are stop loss and a Guaranteed Stop Loss (GSL). There is a critical difference between the two, and both are essential items for a professional market trader. As a trader you need to understand that in using a leveraged tool like CFDs an exit plan is super essential. A regular stop loss simply means the CFD broker will automatically place a limit order at which the price you set once a trigger price has been activated. The danger with this type of stop loss is when the market gaps or dramatically falls and your order doesn’t get filled and hence you would take a much greater loss than you previously planned for. A GSL – Guaranteed Stop Loss, won’t have the aforementioned risk. Once a price has been hit, or passed by the share price movement the trader’s position will instantly be extinguished. There is a small charge for the implementation of a GSL and you may only be able to place a GSL at the time of opening a position – depending on the broker.

We’re nearly finished… one more part to go in this series of "Understanding CFDs".

George Polizogopoulos is a staff writer for MyShareTrading.com, an information hub for traders: forex, shares, derivatives, CFD's. MyShareTrading.com © 2006 All Rights Reserved.

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