CFD Contracts: the Most Important Thing

1CFD-contracts (Contract for Difference, CFD) – is an OTC financial derivative, with which you can profit from price changes in the asset, which is the basis for the CFD (What you need to know about CFD trading).

CFD: general information

A CFD is an agreement between two parties, a buyer and a seller. But the key feature of CFDs is that the owner of the asset does not own the entire asset – shares or futures, etc. – but still receives a profit (or loss). That is, if a CFD is a stock derivative, it is possible to profit from the dynamics of the stock price without formalizing the ownership of the stock. The same applies to other traded assets. When the parties close the deal or when the contract expires, if the asset price and, consequently, the contract price went up, the seller pays the difference between the opening value and the present value. If the price of the asset and the contract fell, then the buyer pays the difference. The most common CFD contracts are for such assets:

• Promotions;
• Indices (most often S&P500, Nikkei 225);
• ETFs in the form of stocks on the NYSE, NASDAQ;
• Futures on raw materials and precious metals;
• Futures on precious metals (gold, silver, Figure 1) and others.
• Technically, working with CFDs does not differ much from other types of markets, for example, securities market.

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But CFDs have the advantage of allowing you to invest less and participate in markets that are not directly available, such as this stock index market. One of the advantages of CFDs is that you can profit from them in a falling market as well as in a rising market. CFD were created in the 90s in order to avoid taxes on investments in stocks. But it turned out that CFDs were able to reach the audience which could not invest big money in trading, because the contracts let them deposit a part of asset’s price. Then the principle of contracts was transferred to other assets. CFDs have become very popular lately also because there are no commissions for this type of exchange.

How to work with CFD contracts?

CFDs are similar to other assets, but there are differences. For example, in comparison with shares, in addition to the fact that the CFD investor does not own shares, he/she cannot receive dividends from the shares when buying them (and he/she also has no obligations with regard to the shares). It is possible to work with CFD with a small deposit, but the peculiarity is that it is possible to use a large leverage. The number of contracts is chosen by a trader. Contract price may be different at various platforms, also there is a minimum size of the contract, starting from which you can start working on the platform. CFDs are based on two classic strategies – long position or short position. The long position is opened when the prices of the asset and the contract are expected to rise.

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In a short position, the trader predicts that the value of the asset will fall and sells. Subsequently, he may enter a long position in the expectation that the price will rebound and go up. On a short position, it is possible to make a profit on a very limited time frame, which is why short-term strategies for CFD trading are popular. At the same time, if the forecast of the downward trend is wrong, the investor will incur a loss, which is the difference in the price of the asset at the opening and closing of trading. If the forecast is correct, he will make a profit in the same amount.

A strategy in which contracts are both bought and sold is also possible. In this case assets should be as close as possible, the trend should be the same. If all conditions are met, such method significantly reduces risks and is recommended to the beginners. When working with CFD, it is considered to be necessary to use stop-loss, which is an automatic closing of the transaction when the price reaches a certain level, in order to avoid losses. Similarly the forex marketThe CFDs allow to work with sums larger (Fig. 2) than the investor has in reality. But there is less volatility in forex than in equities, and in this case the risk of CFD is higher than in the foreign exchange market. But index shares have less volatility, in which case the risk is lower.

Working with CFD is possible 24 hours a day, however, you should specify the working hours for American and Russian shares, if you intend to work with the Russian assets. By the way, when buying CFDs, brokers set commissions, and you should clarify them on the websites of CFD brokers (CFD broker rating). You should also check to see if there are any fees associated with CFDs. Most countries do not, but it is better to find out before you go to work, rather than being confronted with some unexpected news afterwards. CFDs are long term investments and generally follow a simple logic of sequential ups and downs. The only problem is forecasting these fluctuations.

Working with CFDs involves tracking corporate news, but national financial market news is also very important. This type of market is very sensitive to the news background. Practicing CFD players say that the main disadvantage of the market is that the difference between the buy and sell price can be too high. Therefore, it is necessary to look for the brokers with more favorable spreads. Another disadvantage is that CFDs are not fully regulated, so the efficiency depends on the quality of the broker.

The disadvantage that comes from the advantage is the ability to invest on margin. In the case of correct actions, the profit will be large, but if there is a mistake, the losses can exceed the size of the deposit. A specific way to work with CFDs is to invest on long term factors that are determined by the real physical market. For example, the prices of raw materials are formed by supply and demand and this has to be considered when working with contracts. When investing in instruments related to shares of agro-companies, one must take into account the seasonality of this business. CFDs are well suited for short-term strategies, as well as for around-the-clock – it is possible to conduct transactions when the main market is closed.

CFD strategies

Let’s look at several popular strategies for working with CFD contracts.

Working with CFD on the news

Fundamental analysis is quite effective when dealing with contracts. For this purpose it is important to analyze central bank decisions on interest rates, the state of the U.S. labor market, national inflation, GDP dynamics, national export-import dynamics, industrial production indicators and so on. There are many sources of such information (Fig. 3), and each market player can compile his own selection of adequate media resources. Major high-profile events from the “main events” section of the media resources have a greater influence on the dynamics of stock prices.

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This kind of information is supplied periodically, and its main mass is available to all traders at the same time. The one who gets information earlier has certain advantages, but in CFD trading it is not critical. Forecasted events – quarterly reports, annual reports, announcements of large deals. The news allows forecasting the volatility and placing an order with high probability of profit. The practice shows that immediately after the receipt of the significant information the volatility increases and gradually fades as the market adapts to the new events.

The specifics of the CFD market is that news also has an impact on the orders that are already open. This means that it is undesirable to open orders before the expected news release. The best option before opening orders, especially if the positions are large, is to wait for the event to occur and its direction to be clear. Also it is necessary to be always ready to sudden news and to be able to quickly predict their influence on the market.

Hedging

Another one of the main strategies for working with CFDs. It is a way to secure assets against unpredictable price movements or too high volatility. The strategy is considered the most appropriate when investing in CFDs. At the same time, hedging is done in different ways, for example, by opening opposite positions. Also traders can buy and sell contracts in different markets and so on. The hedging strategy is more effective when prices are above the conventional average or when investing in assets that have a wide range.

Another well-known method of working with contracts is swinging, the purpose of which is to profit from small price reversals. For example, on a pronounced uptrend, prices decrease, but then recover. During a price drop, a buy order can be placed. During a downtrend, prices may rebound briefly, at which point you may sell. In this strategy, the main problem is determining the dynamics of the trend.

Breakout strategy of local extrema

Applies to highly volatile contracts, such as WTI, NG futures and so on on timeframes from M15 and larger. It is recommended to hold positions during the day at the London or New York session. Work takes place on candlestick chartThe strategy uses volume indicators and a moving average with a period of 200 (Fig. 4). The goal of the strategy is to wait for a false breakout of the high or low level, to which most market participants will react.

The extremum is chosen based on one’s own understanding of the situation. The investor enters trading when a false breakout is confirmed, which is accompanied by growth of volumes and the direction of the moving average. If the false breakout is not confirmed, the trade can be closed. It is recommended to put stop-losses below the false breakout, take-profit not above the extremum in the direction of the trend.

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Bollinger Line Strategy

Bollinger Lines – one of the most popular tools of technical analysis, which is also actively used when working with CFD (Bollinger Band Trading). The indicator consists of three lines: central simple moving average: 20-day SMA; upper band: SMA 20 with deviation 2; lower band: SMA 20 with deviation 2. Bollinger Bands show volatility. If the corridor formed by the bands narrows, volatility decreases; if they widen, volatility increases. When working with CFD, the Bollinger bands show the points to open the positions for buying and selling. When the price of the asset touches the lower boundary, they open a buy position. If the price touches the upper boundary, a sell position is opened.

Strategy with RSI

RSI (Relative Strength Index, Fig. 5) is an oscillator that shows overbought/oversold values of the market, which range from 0 to 100. The Relative Strength Index is calculated using the formula: RSI = 100 – 100/(1 + RS), where RS = the average value of the increase in the closing prices of the selected period/the average value of the decrease in the closing prices of a certain period. Interpretation of oscillator indicators suggests that RSI above the level of 70 means that the market is overbought and the trend reversal to lower prices is possible. If RSI is below 30, the asset is oversold and the trend can reverse to higher prices. When working with CFDs, a buy order is placed if the RSI is above the 30-point mark. If the RSI line falls below 70 pips, a sell position is opened.

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Strategy with MACD indicator

MACD – is a moving average convergence/divergence oscillator, which is designed to calculate the difference between fast and slow moving averages (Trading by MACD with Fast RSI). The calculation is based on three moving averages with smoothing, which makes this oscillator quite accurate. When the MACD readings are above zero, it means that buyers dominate the market, and if the readings are below zero, it means that sellers dominate the market. MACD is actively used in CFD, if the oscillators are above zero – a signal to sell, if it is below zero – a signal to buy.

Strategy with Fibonacci levels

Fibonacci Levels – a popular market tool based on the Fibonacci number series. There are several Fibo indicators, and levels are the most popular of them. Asset prices are believed to tend toward levels in the order of Fibonacci numbers, and when approaching them, the price can change direction, and when breaking them, it shows the continuation of the trend. According to the indicator indicators, positions are opened when trading with CFD. The levels are also suitable for determining take profit and stop loss points.

Strategy with ParSAR

ParSAR (or Parabolic SAR) is a trend indicator, which represents as a series of points placed below or above the price on the chart. If indicators are placed under the price – the trend is upward, if under the price – the trend is downward. The indicator is used to work on a strong trend (Strategy Based on Parabolic SAR and RSI Indicators). The work with contracts is carried out between the broker and the player. CFD is developing very actively, so it is not difficult to find a platform to work with. The possibilities of CFD are Admiral Markets, Arotrade, IFCMARKETS, eToro Group and many other CFD brokers. We advise to pay attention to the best brokers from our rating: Alpari and BCS Forex.

Conclusions

CFDs have a number of advantages which make this type of investment attractive and effective. But it also has some disadvantages – high spreads, insufficient market settlement. CFD is a high-risk asset, first of all, because a market player can work with a minimum deposit for really big amounts. This is an advantage that turns into a disadvantage if used incorrectly. Therefore, it is necessary to approach the contracts in a disciplined manner and devote enough time to work on a demo account.

Technically, the work with CFD does not differ from other types of markets, the terminal does not differ in principle from forex, the strategies can be applied, in general, similar. In contrast to forex, awareness of the world and corporate events is of great importance for CFD. Therefore, market participants should choose the quality news and follow it regularly.