CFD Trading and Managing The Risks
14 Jul 2016 in Business
Like all financial products, there are risks trading CFDs. The risk is linked to returns, the riskier the investment, the higher the potential returns, however, if the risk is managed correctly it can be significantly reduced. When trading CFDs, this can be done through the use of a variety of orders and simple portfolio hedging.
CFDs or a contract for difference is a trading tool that you can use to trade forex. It works on the principle of leverage. Leverage is the most significant reason as to why forex is risky or why people say it is so. Leverage allows you to deal in a trade with only a percentage of the amount. So if the trade deal is for $1000, you can get into the deal for around $200. Although this is beneficial as it allows you to get into big deals with small amounts, you always have to be on your toes when dealing with leverage and CFDs. The leverage factor alone is not dangerous as it in a way amplifies your loss. However, people have many misconceptions about the entire concept, and they make wrong calculations leading to losses.
Before CMC Markets trade they must understand that CFDs are a leveraged product and that leverage can work for you as well as against you. Like all leveraged products a small price movement can result in significant returns but also significant losses. The variety of orders types available for CFD traders allows the risks associated with adverse price movements to be significantly reduced. CFD traders can set their orders at prices which they are prepared to close out their positions and realize a loss
The Risk With Leverage
Leverage in no way means that if you invest some money, you will lose more than you invest. All it does is allow you to deal with larger sums of money that would otherwise have been out of your reach. The risk comes in when people begin to think that with leverage, they will get rich overnight or will suddenly make big bucks on a small amount. This makes people pump in more money than they should and puts them at a risk. The other risk with leveraged products is that a small price increase will result in large profits as you are dealing with a large number of CFDs, but a decrease will also mean huge losses.
Common order types used to mitigate risk are stop-loss orders, trailing stop-loss orders and guaranteed stop-loss orders.
This is the most common type of order used by traders to manage risk. A stop loss order is simply an order to close an open position that is placed at a price below or above the current market price at a price that the CFD trader is willing to close out their open position. It is important to note that stop loss orders can be prone to slippage should the price of the CFD gap, this is a common occurrence when trading share CFDs.
Trailing Stop-loss orders
Trailing stop orders are similar to stop-loss orders with the exception that the price of the order moves by a pre-determined distance from the current trading price, this distance is set by the trader at the time of placing the order. It is important to note that the price of the order will only change if the price of the instrument moves in a favorable direction, should the price move against the trader the price of the trailing stop order will not change. This order type works like a ratchet, in that it can be used to lock in profits as the position moves in favor of the CFD trader without the need for the trader to constantly change the price of their stop-loss order.
Guaranteed Stop-Loss orders
Guaranteed stop-loss orders have become common in recent times due to traders being able to guarantee their potential losses. This order type is commonly used when trading share CFDs simply because share CFDs are prone to slippage and gapping during the opening phase of the market. It is important to note that when using guaranteed stop-loss orders your CFD provider will often charge you a premium, this is like an insurance premium guaranteeing that you will be filled at the price your stop-loss order is placed.
Aside from using orders to manage your risk when trading CFDs, many traders use other financial products such as shares and options to hedge their CFD positions.
Shares are commonly used to hedge CFD positions or vice versa; these are often used by traders that hold a portfolio of stocks as well as a short-term CFD trading account. CFDs are often used to trade short-term price movements of the stocks within their portfolio without having to sell their stocks and realize any capital gain.
Options are used by some CFD traders as a form of guaranteed stop loss. Options have an advantage over guaranteed stop-loss orders in that they are often cheaper. Hedging CFD positions using options is commonly used by more sophisticated traders that understand the core components of an options contract and how to choose the most appropriate contract to hedge their CFD position.
Aside for managing risk using order types and hedging strategies, all CFD traders should ensure that they adopt strict money management techniques, meaning that they should not utilize excessive leverage or over expose themselves to one particular CFD or sector. Utilizing too much leverage is the single most common mistake made by novice CFD traders.
Before opening a real CFD account, you should ensure that you practice trading on a demo account to so that you understand how to use the multiple order types available that will help you manage your risk. Remember CFD trading can be extremely rewarding if the risks are controlled.
How To Avoid Risk
When you trade CFDs, you have the advantage of using stop losses. Understand how they work and how they will help you so that you can put them to good use. With a stop loss, you can set a point up to which if the exchange rate falls when you will automatically withdraw without further delay. If the rate goes up, you can use the advantage of the trailing stop loss to take your previous stop-loss point up about the new rate. This will help you minimize losses and decide what your losses can be beforehand.
Do not go running around looking for a gold mine, this is a continuous investment and will take a time to bear fruit. So, have patience and do not keep switching mindlessly. Also, do not chase the lowest margins possible, the greater the leverage, the higher the percentage of loss.
If you have to switch your forex, trade in small CFD deals and get an idea of the new investment instead of plunging in blindly. Risks sometimes pay off but take only calculated risks. Study the market and all possible sources before going into a new deal; this will give you a good idea of its worth.
Like in speculations, never trade with the money that you need to live on or your savings. This one risk is always dangerous.
Develop a CFD trading method, when you deal with CFDs, you should have a proper method of investing that will minimize any risk to a great degree.