A Contract for Difference (CFD) is a derivative trading instrument that allows investors to speculate on the fluctuation of the price of an underlying asset. Traders can buy (long) or sell (short) the asset depending on how they expect the price to move over time.
Because they allow investors to trade the value of the underlying asset, they do not involve real ownership of the asset, for instance, a company stock, commodity, crypto, forex, or index. This factor also gives CFDs a major trait, allowing investors to spread risk exposure across multiple instruments and global markets from a single platform.
Understanding CFDs
A contract for difference is essentially an agreement between an investor and a broker from the time the trade is opened until it closes. Unlike trading regular assets, trading CFDs allows traders to use leverage, enabling them to work with higher capital than they have in their account.
Leverage can range between 2:1 and 100:1, or even higher depending on regulatory frameworks in various jurisdictions.
A leverage of 5:1 and a capital of $1,000 means a trader has $5,000 to work with, which is essential for retail traders starting with small capital.
By magnifying investment potential, traders can use leverage to invest across multiple assets globally, thereby spreading their risk exposure.
How to Diversify Your Portfolio Using Global CFDs
Because different global jurisdictions have different risk factors, it is always good to start with as few jurisdictions as possible, say for instance two. The US market and the EU market. If possible, begin with the asset types that you understand better, for instance, commodities and stocks.
One of the most common strategies used by sophisticated traders is hedging your stock holdings with indices. In this case, if you own a consumer goods stock portfolio, you can hedge against trisk exposure with a commodity CFD or an index CFD, in another region.
If there is a consumer goods stock meltdown in the US, the EU’s DAX30 may be a good hedge. That is just an example, not to be taken as advice.
Risk Aspects to Consider When Trading CFDs
The ability to use leverage is one of the main advantages of trading CFDs. However, while it can magnify profits, losses too can be magnified and run out of control if your open positions move in the opposite direction.
Therefore, risk management tactics are essential to ensuring trading losses are kept in check. This can be done through keeping the position size manageable relative to your capital. Some experts recommend a maximum of about 2-3% exposure per position, for an account with 5:1 leverage.
This means, if you operate a $1000 account, with 5:1 leverage, you should not risk more than $150 per position.
Traders should consider how much overall is risked across all open positions at one time, with experts pointing to a maximum of 10% as ideal. In our example, this means a maximum exposure of $500.
Another risk to consider when trading CFDs is overnight costs. These are fees charged by the broker for keeping your trades open for more than a day. It also explains why CFDs are perfect for day traders, but not recommended for long-term investors.
Because leverage can quickly magnify losses, traders should also use various trade management tools like stop-loss and take-profit to limit the adverse effects of slippage, especially during dynamic market conditions and news events.
CFDs allow traders to access trading instruments from all over the world on a single platform. This can be a great feature for diversification strategies, but can also be tricky when not used with care.
For instance, traders can find themselves trading two correlated assets that appear different at the same time in the name of diversification. These assets can appear to be inversely related, but still behave similarly in volatile markets. Therefore, it is always good to assess the underlying assets’ behaviours properly before hedging them against each other.
Conclusion
In summary, CFDs can be an effective instrument for trading global markets from a single platform, thus making it easier to diversify your portfolio without worrying about the regulatory frameworks of different jurisdictions.
However, they also feature notable risks, which must be navigated using a well-thought-out risk management strategy.
