FREQUENTLY ASKED QUESTIONS
A CFD (contract for difference) is a financial instrument which is based on an underlying and allows an investor/trader to experience all the benefits and risks of owning that underlying without actually owning it. The CFD will reflect the underlying’s movement, either a stock or an index or other kind of asset, and it has no expiration date. Because it is used with leverage, it is a powerful tool in the hands of an informed trader, but it can also cause excessive losses in a portfolio where too much leverage is used or where no loss limits and proper risk management are applied.
A security whose price depends on, or is derived from, one or more underlying assets. The derivative itself is simply a contract between two counterparties. Its value is determined by the fluctuations of the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indices. Most derivatives are characterized by their high leverage. Futures contracts, forwards contracts, options and swaps are the most common types of derivatives.
A cross currency is any currency pair in which neither currency is the US dollar. These pairs exhibit erratic price behavior as the trader can, actually, initiate 2 trades using the USD. For instance, initiating a long trade (buy) in the EUR/GBP, is equivalent to buying a EUR/USD currency pair and selling GBP/USD. The most frequently traded currency pairs would require a higher transaction cost, but they are just as lucrative in terms of return.
Hedging is the practice of carrying out an investment activity which allows you to protect yourself against the losses of another. For instance, a short sale to protect a previous purchase, or a bullish purchase to offset a previous short sale. While hedges reduce potential losses, they also tend to reduce potential gains. However, it is always advisable, and it is actually a common practice for all experienced traders, to apply hedging strategies when opening a position, as it leads to a more effective risk management which is key to operational success. And options are really the key in this process.
Leverage is the connection between the amount of capital used in a transaction and the required collateral deposit (margin). It is the ability to control large amounts of a security with a relatively small amount of capital. Leverage varies dramatically among traders, ranging from 2:1 to 400:1. Leverage allows a trader to participate even in fractional movements of the market, or to magnify his profits. However, it should be applied with special caution, since there are also significant risks for those who do not know how to use it.
When you open a new margin account with a broker, you must deposit a minimum amount into your account. This minimum varies between brokers and can be as low as $100 or as high as $100,000. Each time a new trade is executed, a certain percentage of your account balance will be set aside as the initial margin requirement for the new trade depending on the underlying currency pair, its current price, and the number of units (or lots for FX) traded. The lot size always refers to the base currency. For instance, let’s assume that you open a mini account which provides 200:1 leverage or 0.5% margin. Mini accounts can trade with mini lots. Let’s say that one mini lot equals $10,000. If you were to open a mini lot, instead of providing the $10,000, you would only need $50 ($10,000 x 0.5% = $50). Margin trading also applies to other products such as stocks and indices.
Slippage occurs when you do not get the expected price (or even very close to it) when you open a trade in the market or while stopping a loss. This can happen for any of two reasons: the market price is simply moving too fast/the market is illiquid, or you are opening trades through an unmotivated broker who does not apply a proper execution policy. Sometimes this will be the difference between using a market maker instead of a direct execution broker.
Options and their combinations, such as calls and puts, help you to hedge but also to speculate and even modify a losing trade in an efficient and profitable manner. There are many combined positions a trader can use to gain some exposure to the market. Some strategies for these combinations include options sold for hedging or even short selling options and volatility trades. Their pricing is based on several variables which make them attractive to all investors. It is essentially a contract between 2 parties who agree to exchange an underlying asset (whether a stock, an index or a commodity) at a specific price within a specific time frame; however, 98% of all positions are settled in cash on P&L terms and no physical delivery is made. Options give you a great flexibility compared to other tools, as they can help you establish positions that are not just directional; that is, they can be long or short, but they also take advantage of volatility or lateral movements or even slow markets or act as income generation tools.