Understanding how CFDs work in financial terms and how they respond to market dynamics is one thing, but it doesn’t cover a very key and often overlooked element of the CFD trading puzzle. The duration of the trade is a balancing act that takes experience and inevitable trial and error to learn, and the longer you hold on to a position the more complicated it becomes to crunch the numbers and work out if it’s a viable proposition. Deciding which over a long or short term strategy is best suited to a particular trade is something you need to judge with finesse, and only by understanding the key advantages and disadvantages of each alternative can you begin to piece together a comprehensive set of trading rules. To say CFD trading was exclusively a short-term instrument would be incorrect, but there are certainly advantages to getting rid of your CFD position sooner rather than later.
Trading contracts for difference effectively requires a defined strategy that governs how you trade. Particularly for inexperienced traders, establishing a set of trading principles means you are more tightly confined in your trading style, which is most certainly a good thing insofar as it cuts down on the scope of your research and decision-making labours.
Your trading style ultimately depends on the amount of time you can dedicate to CFD trading but mainly there are 3 categories, namely, day trading, short-mid term, and long term trading.
Day Trading Benefits
Trading contracts for difference effectively requires a defined strategy that governs how you trade. Particularly for inexperienced traders, establishing a set of trading principles means you are more tightly confined in your trading style, which is most certainly a good thing insofar as it cuts down on the scope of your research and decision-making labours.
One of the most popular styles of trading CFDs, as with many other instrument and asset classes, is known as day trading. Day trading is the process of buying and selling CFDs over the course of the trading day, closing out your positions before the day is through and seldom ever rolling a position overnight. This approach, while often difficult to master, presents several notable advantages for CFD traders, and can be an effective strategy for new and inexperienced traders.
One of the strongest arguments for day trading with CFDs is that it allows traders to take advantage of leveraging without incurring finance costs – effectively enabling the advantages of leverage without the costs. Of course, the risk of highly leveraged positions doesn’t disappear, but the costs of finance can be removed from the equation by choosing a day trading strategy.
As a margin traded product, CFD transactions are majorly funded by loan finance, provided by the broker to allow leveraged trading. Of course, finance doesn’t come for free, but interest charges are only applied on positions that are held for a period longer than one day.
As a cost that comes directly from your trading profits, cutting out financing expenses can make a significant difference, particularly over time, and acts as a direct financial incentive for investors to trade over the course of just one day. By reducing financing costs, the price movements required to render a profit on each transaction are much lesser, making it theoretically easier to keep your position in the black.
Another prominent advantage of day trading is that the risk of each transaction is slimmed down, in comparison to positions held for a longer period. While CFDs tend to be volatile, that volatility and the resultant risk is boxed in when trading over the course of one day, because prices can only fall so much. This means that while the day trader will engage in more numerous CFD transactions, the individual transactional risk is limited because of the shorter duration of each trade.
On the flip side, this same advantage results in some corollary drawbacks, and naturally, day trading has its own share of difficulties that must be balanced. Because each transaction is limited to a maximum of one day, this ultra short-term strategy drives smaller profits per transaction than the profits that are expected from longer-term trades. This means that traders are required to take a more active role in researching and sourcing transactions, which results in a much larger ongoing workload. Simultaneously, increased transaction volumes result in increased commissions and transactional costs, which must be offset against anticipated trading income.
Day trading is a popular strategy for traders who don’t mind playing an active role in their investing, and who are looking to narrow down the parameters of their research. While as an approach day trading CFDs can be comparatively less risky, it is nevertheless a challenging strategy to implement effectively, but profitable for those adopting the right approach.
Short-Mid Term Trading Benefits
The benefits of trading CFDs short term make it primarily an instrument used for more dynamic trading. Whether you’re going long-term or short-term, the advantages of leverage remain the same, and the earnings potential is arguably greater the longer you ride out a profitable swing. However, the real distinction lies in the increasing costs of funding a CFD position over time. Essentially, a CFD position that is viewed as delivering a short-term return is a much more simplistic prospect than one which is to be held over a period of weeks. With short-term CFD positions, you only need the market to move marginally in your favour to deliver a return and bag a profit. Without ever suggesting that CFD trading is easy, a shorter-term trading outlook, while relying on a greater trading volume and research burden to deliver comparable returns, is much more straightforward to calculate and execute successfully than a more long-term position.
When you trade CFDs over the course of a day or two, your profit computation need only be concerned with looking at the raw transaction costs. How far does my position need to move to yield a profit, taking account of the costs of commission? This becomes a far easier calculation when you’re looking at a flat 0.5% charge on transaction sizes, which makes split second decision making more straightforward while also saving money on aggregate with positions that require less of a movement to deliver a return.
Long Term Trading Benefits
Conversely, for traders looking towards more long-term positions, the issue of funding leverage becomes all the more pertinent, and makes the arithmetical calculation much more difficult for on the spot decision making. Furthermore, long-term positions are expected to work harder and more consistently in order to offset the creep of financing costs into profit. A long-term position with a constant value will lose money, because the daily costs of financing will start to very quickly eat into any profits the trade has notionally realised. For this reason, it’s imperative that positions envisaged as being held over the longer-term are chosen on the basis of their longer-term earnings potential, given the need for a run of good trading days in order to maintain the value of the position.
That said, long-term trading positions have advantages of their own over shorter-term positions – namely that they can by definition deliver greater returns. If you jump on board a three-day price reversal at the right time, you can expect to be very much in the money. But this of course depends on whether you can offset the costs of financing the size of your position each night. Assuming the financing costs work out to be less than the gains made over the course of the three-day period, the benefits of an extended period of leverage will outweigh the drawbacks.
Similarly, trading long-term means trading with less volume, which helps cut down on the ongoing costs of broker commission. While this isn’t usually a significant amount on individual transactions, any switch in strategy would also need to factor in the savings from trading less frequently in calculating which was more cost effective.
In all practicality, some situations will call for a short term trading stance, whereas others will benefit from being held over for a longer period. So long as you understand how CFDs perform differently over time, you should be adequately positioned to make these kinds of calls as to how and when best to trade CFDs.
Having looked at how CFDs work in some depth, how they are priced up and how they can be traded to accommodate different market scenarios, we now turn to our final consideration in the investigation of what makes CFDs tick – the interplay of indices, markets and orders for CFD speculators.