Are you considering opening a trading account that will allow you to utilise the CFD trading instrument to leverage the market price volatility of individual asset classes? If so, do you know what the difference is between the different asset classes, and how they can be uniquely leveraged to increase your wealth portfolio?
Contracts for difference: What, how, why?
Before we look at what asset classes are best suited to the different trading strategies and end goals, let’s have a quick look at what a CFD is and how it is designed to work.
Let’s consider the succinct, paraphrased definition as supplied by Investopedia: A contract for differences (CFD) is an agreement between two parties, set out in a legally binding contract; whereby, the price variations (between the opening and closing price) of a linked asset are paid to either of the two parties by the other party.
Possibly the best way to describe the CFD’s function is to cite a small case study. At the outset of our case study, it’s important to note that the primary purpose of a CFD is to leverage the small price movements of an underlying asset without holding the asset. In other words, the higher the price volatility the greater the change of profiting from the small price fluctuations that occur within the trading day.
It is also vital to be cognisant of the fact that the underlying asset class linked to the CFD determines the trading strategy to a large extent. The salient point here is to look at the price volatility during a specified period.
In short, asset classes such as Forex and cryptocurrencies are well suited to very short-term trading strategies because they experience very high price volatility levels. While, on the other hand, asset categories like commodities, stocks, and bonds, are better suited to longer term trading strategies as their price movements tend to be less unpredictable.
CFD cryptocurrency trading: A case study
For the purposes of our case study, let’s assume I want to grow my investments by getting involved in trading cryptocurrency CFDs. The following steps are a simplified version of the process that I need to go through to trade cryptocurrency CFDs successfully.
The first step is to sign up with a brokerage firm like Jones Mutual who offers a wide variety of cryptocurrency CFDs. This will allow you greater latitude when selecting the right asset for your goals.
Once you have signed up with the broker of your choice and completed all of the legalities like paying a deposit and submitting the legal “Know Your Customer” documents, the next step is to determine which crypto CFD you would like to use to trade on.
A substantial amount of research should go into this process. It is vital to look at both fundamental analytics and technical indicators when deciding when to enter and exit the trade.
For the sake of a complete explanation, fundamental analysis consists of looking at the world’s macroeconomic policies. When trading on Forex and cryptocurrency CFDs, it is not necessary to pay attention to the relevant country’s micro-economics.
Forex and crypto prices are not affected by how well a particular company is doing. This fact can be seen as an advantage of Forex trading over other asset classes. Ergo, fundamental analysis is much simpler when trading on crypto and Forex CFDs.
Technical indicators like the RSI (Relative Strength Indicator) and the Bollinger Bands are used to indicate trends. Using these two indicators are usually sufficient to determine an underlying asset over a period. The rule of thumb is to buy low and sell high. Both the RSI and the Bollinger Bands over a candlestick graph will show the resistance level, support level, and the potential breakout points.
Once the requisite due diligence on the underlying cryptocurrency in the form of technical and fundamental analysis has been conducted, the next step is to decide on the trade size. The number of tradeable units is mostly dependant on the available trading capital. Also, one of the best ways to limit exposure to risk is to work out the size of each trade by the 5/15 rule.
For example, if there is $5000 (USD) total trading capital, three trades of 5 units each can be placed, up to a maximum of 15% of the total available amount. Each unit is equal to 1% of the total value ($50). Therefore, 5 units is equivalent to $250. Three trades of $250 each is equal to $750 which, in turn, is equal to 15% of the total amount.
Finally, the only thing left to do is to enter and exit the trade at the chosen levels.