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  • CFD Trading in Volatile Markets Mar 30, 2020

    Recent global events brought an almost unprecedented volatility to the financial markets, with huge drops in the leading stocks, indices, currencies and commodities and record breaking increases in value of some of these assets.

    While volatility can present significant risk for the inexperienced investors, seasoned traders usually perceive it as an opportunity to magnify their potential profits.

    These traders use a variety of instruments to trade volatile markets and we will focus this article on CFDS - Contracts for Difference, which is one of the most popular instruments in the market today.

    What are CFDs
    A CFD is a financial contract between a trader and a broker that pays out the difference between the initial and settlement price of an asset at a specific date and time. It is a derivative product, which means it allows traders to try and predict changes in underlying assets without actually owning them.

    In simpler terms, these instruments allow traders to try and predict upward or downward movement in the price of an asset. If they believe the price will go down, they go short and if they believe the price will go up they go long. They will earn the difference if the price moves in their favor and pay out if it moves the other way.

    CFDs are similar to other derivative instruments like futures and options, with some differences:

    • They can be used to trade a wide variety of instruments, including cryptocurrencies

    • CFD trading is carried out over-the-counter

    • They have relatively small barriers to entry with positions as small as a single share

    • CFD contracts are normally valued on a 1:1 basis with the underlying financial instrument
    Short Term Trading
    As we mentioned before, volatile markets present both a risk and an opportunity for investors to trade on price movements, using derivative instruments like CFDs, especially in short-term trading.

    Short-term day traders are especially inclined to use CFDs. They rely on short term movements to try and make profit. Through the use of technical indicators, and in some cases economic indicators, they try to time the market and place positions in their favor, hoping to catch the right side of the trade. They use CFDs to facilitate these short term trading techniques.

    Long-Term Trading
    Investors holding diverse portfolios with long-term holdings may use CFDs to hedge (reduce the risk) adverse changes in the markets that may cut into their portfolio value.

    The strategy involves using CFDs to take a short position in the event they believe their shares (or another underlying asset) will decrease in price. Through the use of the short position, the investor will try to offset any losses suffered by their long-term holdings through the profits made on the CFDs.

    CFDs are considered to be high-risk investments that are usually more suitable for advanced traders.

    The use of leverage (funds borrowed from the broker) allows the trader to take larger positions. While this might offer great profit potential it also magnifies the losses.

    That's why margin has to be used wisely and responsibly, while considering financial capabilities and calculating the positive and the negative potential of any trade prior to execution.

    Tips for Trading in Volatile Markets
    While volatile markets offer opportunities for investors they are almost never predictable. Here are some tips that will help you reduce the risk of trading in general and especially when the market fluctuates.

    1. Choose a licensed broker

    There are several financial licensing authorities in the world today and most important ones are CySEC (Cyprus Securities and Exchange Commission) and FSCA (Financial Sector Conduct Authority). To receive a license from one of these authorities an online broker must follow strict rules, aimed at securing the customer's funds and personal details. So before you choose an online broker, make sure that it is licensed by one of the licensing authorities. Brokers usually present their licensing information at a prominent position on their home page. Some online CFD brokers, like for example are licensed by one authority and registered to multiple others, which allows them to offer their online services for customers from different areas of the world.

    2. Make a plan and stick to it

    Volatile markets are hectic, unpredictable and surprising, with unexpected swings to both sides. Some traders let their emotions rule their actions, which may result in bad decisions. It is very important to have a plan, clarifying loss limits, and to stick to it in the trading cycle.

    3. Determine position sizes according to your financial capabilities and risk appetite

    It is always wise to trade according to your financial capabilities and risk appetite and this is especially true in volatile markets.

    4. Use stop-loss and take profit orders

    The stop-loss/take profit orders are instructions placed on the trading platform to automatically close the position at a specified price once it hits that level. It allows traders to predetermine the loss they are willing to suffer and the profit they will be happy with. It also saves them the need to follow their positions and manually close it.

    A Final Word
    While volatile markets present a great opportunity for experienced traders they are also very risky. Trading with caution, while using predetermined strategies will help you minimize your potential losses and hopefully make a nice profit.