Managing Risk with CFDs

Managing risk is a key element in trading and actually the most important element in becoming a successful trader. Managing risk is even more important with CFD trading than with most other forms of trading because the potential for risk is so high if not managed properly.

Options trading is thought by many to be the riskiest form of trading, at least potentially, and one could expose their entire account to a long shot bet if one wanted to, to a far out of the money option that had a very low probability of doing anything but losing all one’s money.

Managing Risk with CFDsOf course it wouldn’t be sensible to use such a strategy or anything close to it unless the goal was to blow off one’s account. CFD trading has the potential to do that as well, but in even more dramatic fashion. Unlike options, you can potentially lose significantly more than the money you put up as margin with a CFD.

This is true with futures trading as well, but futures traders tend to come to the game with a better understanding overall of the risks involved. CFD trading attracts a lot of less experienced, more casual, and newer traders who may not appreciate enough what one may be subject to and how to manage these risks.

Brokers have to disclose these higher risks to traders who trade any sort of derivative, including options, futures, and CFDs, as well as any trader trading on margin. Margin trading in itself presents additional risks because one’s exposure to losses is potentially greater than the margin one puts up for the trade.

CFD trading is like futures trading in that the trader just puts up a deposit for a small fraction of the value of the asset under control with the contract, and the downside of the trade may involve greater amounts than the deposit.

CFD brokers will seek to close out trades well before all your deposit is used up, although if the market is closed and then opens up big time against you, you can indeed lose more than you put up for the trade. Neither stop losses or margin calls can protect you against such price movements.

Using Stop Loss Orders with CFDs

If stop loss orders are essential to any sensible trading, they are even more essential for CFD trades, due to the higher amount of leverage involved with CFDs. Any good advice on trading will strongly emphasize the need for using stops in every trade, and they are even more important with CFDs, even if you never take your eyes off the screen during a trade.

The advantage of CFDs is that we can shoot for a lot higher gains with the leverage that CFD trading provides. This can be a very big advantage indeed if managed properly, but when it is not, it can cut the other way as well, and cut pretty big in fact.

If you are magnifying the effect of price movements 10 times, 30 times, or more, it’s nice to be able to rack up a lot bigger profits when your trades work, but you do not want to expose yourself to too much of this much higher potential for losses if they don’t work, and especially if they don’t work big time.

Those not familiar enough with managing risk may think that we then should be dialing down the leverage on CFD trades significantly to avoid all this, or maybe not even trade CFDs at all. While you can and should manage risk exposure by managing degrees of leverage, you always want to manage this with stop loss orders.

Whenever one is in a trade, one can specify how much one is prepared to lose in the trade by placing a stop loss order. Stop loss orders should be used in any trade and with even longer- term investments, to not only limit how much we lose, but also to set a price where if hit the trade is no longer desirable to be in.

Not having a clear exit plan is how both traders and investors get hurt. Stop loss orders function to put the maximum loss that we are prepared to take into an executable order.

People get stung by stock market crashes for instance because they do not have a stop loss in place, although it may be the case that the investor doesn’t care and may be prepared to take whatever level of punishment the market may dish out.

It doesn’t make any sense for a trader to ever take this approach, as the goal of traders is to be in at the right time and be out at the right time, and there is always a move that will in itself tell us we should no longer be in the trade.

There is certainly the risk that we will set our stops too tight and have them exit trades too often, but this is all part of managing the trade and first and foremost we need to use these orders to protect ourselves, especially with CFD trading.

The goals of stop orders aren’t just to set a certain amount that we don’t want to exceed as far as losses on trades go, as if used properly, they will be integrated into our trade strategy and be used to exit trades when our strategy would dictate. If the movement against us is significant enough that the probability of it going against us exceeds the probability of it being in our favor, then that’s a good reason to be out as well.

First and foremost though, stop orders protect us against losing too much on a trade, and losing too much on a trade is something we do always need to avoid.

Managing Gap Risk

The more leverage you use, the more you are exposed to gap risk, which is the risk that the market for something will open up with a gap against your position. For instance, you may be in a trade where the market opens up 10% against you, and this can produce big losses if you are highly leveraged.

Gap risk isn’t something that is talked about that much, no where near enough in fact, but it is a real danger that must be respected. This is not to say that CFD traders should not expose themselves to gap risk, but if they do, they must tread very carefully.

Even back in the days when those who trade stocks intraday were only permitted 2:1 leverage, most of these day traders would never keep a position overnight, and the reason was that this involved gap risk. This is even more the case now that stock day traders can enjoy 4:1 leverage.

While it’s true that stocks are particularly exposed to gap risk, much more so than indexes for instance due to their much greater diversity, anything can gap when its market has been closed, as there are factors that may influence pricing that occurs during this time.

When you are leveraging yourself even more than this, it is even more important to manage this risk. While a lot of CFD traders do expose themselves to gaps, you simply cannot use the same amount of leverage or anything really that close as you could if you do not hold positions during market closures.

With CFDs allowing for trading in markets that are open virtually around the clock 5 days a week, this may only mean that one does not hold positions over the weekend. Forex is ideal for managing this risk because it doesn’t close through the week. Indexes and some commodities trade almost all week, with a few short breaks that only expose the investor to a half hour to an hour of down time, which is at least a lot less of a time frame than overnight or over the weekend.

Managing Risk with Position Sizing

With CFD trading, as is the case with all forms of margin trading, one can control the amount of risk exposure simply by controlling one’s position sizing. If one has 10,000 in an account and the leverage is 100:1, one can simply choose the amount of desired leverage by putting a certain percentage of one’s funds in play and keeping a certain percentage in reserve.

In this instance, if one wanted to trade with 10:1 leverage, one would trade with $1000 and keep $9000 in reserve. Any percentage of leverage can be achieved this way as the trader may desire.

New traders are often not familiar with this simple strategy and may just go with the maximum all the time, which may end up being a recipe for disaster if this involves exposing oneself to too much risk.

Even with stop losses and not holding positions when the market is closed, this can result in problems. One can set tight enough stops to limit the amount that one is prepared to lose on a trade, but trades need room to breathe, and you don’t want to be constantly taken out of trades by what amounts to insignificant moves against you.

This is why using the most leverage you can obtain is not always the best way to go, and very often is not. The trade must fit the strategy, and if in following your strategy, doing so with a certain amount of leverage will place one at risk of too large of a loss, the leverage needs to be adjusted to fit the trade.

The shorter the time frame of the trade, the more impactful a move of a certain percentage will be on the trade, and this is the real reason why more leverage can be used sensibly with shorter term trades.

On the other hand, the longer the expected length of the trade is, the more room these trades need, and the less leverage you can use with them.

Trades that involve being exposed to gap risk need even more room, and while there’s no real good way to protect against gap risk fully, one must make sure that the risk is still kept reasonably acceptable.

The dynamics of CFD trading do reward shorter term strategies though, as long as one is able to come up with successful ones, and shorter term trading does require more skill. There are many traders who end up becoming swing traders, holding trades for days to weeks, because they haven’t been able to figure out good ways to be successful with intraday trading, which is indeed a bit more challenging but not as much as many traders think.

Regardless though, one must ensure that one is not overly exposed to risk when trading CFDs. These risks can be managed very well actually, but only when we pay enough attention to them and account for them enough.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: andrew@marketreview.com

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