In Part 3 – What to expect…
The leverage that CFDs provide is their greatest opportunity; however, it is also their greatest risk. One common risk with trading in CFDs is that traders continue to spend the same amount of money as they did when buying shares. Consider a trader who bought blocks of $9000 parcels of shares in the stock market, who starts to trade CFDs. With shares, the trader could buy 1000 shares of Bluescope Steel (BSL) at $9; however, with CFDs, he or she is now controlling 10 000 shares for $9, assuming a 10 per cent margin requirement, as shown below.
This works well when the trades go your way because your returns are amplified 10 times. If BSL was to rise to $10.20, the share trader makes a gain of $1,200 or 13 per cent on the original investment of $9,000. The CFD trader made $12,000 or 133 per cent return on the original $9,000 investment.
But risk management is not about what happens when a trade goes right; it is what happens if a trade goes wrong!
If BSL fell to $7.30, as shown above, the losses for the share trader will be $1,700, or 19 per cent of the original capital invested, yet the CFD trader is now down $17,000, or 188 per cent, which is more than the trader’s original investment.
With CFDs, it is very hard to ride the swings in equity that occur, and employing risk management is the key to successfully trading CFDs.
When trading CFDs, stops are essential. This is the only way to control your risk when in the market. If you buy an option or warrant, your risk is limited to your original investment, but with CFDs there is no limit. Your risk is potentially much larger than this. Stop orders are available from all CFD providers and should be used whenever you place a trade.
CFDs have no built in risk management strategy, so it is vitally important as a CFD trader that you learn to manage your own risk. To be profitable, this is essential. Successful trading is about successful risk management.
As mentioned, making money with CFDs is easy; keeping it is far more difficult. The only way to manage your risk effectively is always to use stops.
Your stops must be placed into the market, not in your head. Stops in your head do not limit risk because a market can move very quickly or you can end up changing your mind when it comes time to execute your stop loss.
A stop order is not a guarantee that you will sell at a fixed price. For example, a stop placed at $38.00 in CBA, as shown below, would not have sold you out at $38.00 because the share never traded at this price. It would sell you out at the opening price the next morning at $37.01
Some CFD providers allow you to place a guaranteed stop order. With a guaranteed stop on CBA at $38.00, you would sell at $38.00, even though the share never traded at this price. Generally, a CFD provider offering Direct Market Access (DMA) will not provide a guaranteed stop loss, while the market makers will.
All CFD providers place restrictions on the placement of guaranteed stops, and all charge a fee when the guaranteed stop is placed. For example you may be required to place your guaranteed stop no less than 5% away from the current share price and you may only be able to place them over the phone during certain times of the day.
Check with your provider how it’s guaranteed stops work and the fees and restrictions associated with using them.
A Gap when trading simply means today’s opening price is different to the closing price from the day before. For example the closing price on Tuesday may have been $4.50 and the stock opens on Wednesday morning at $4.55 resulting in a Gap from $4.50 to $4.55. In this case the buyers wanted to get in a any price and the sellers were holding off resulting in a match out of price 5 cents above Tuesday’s closing price.
Gaps can have a large impact on your trading account and can potentially wipe out a CFD account. Gaps occur for two main reasons, either because of a strong reaction to a company-specific event or because of the market being unable to adjust to an event that occurs outside trading hours.
An announcement of a takeover bid can cause a share to gap up strongly during trading hours, or news of a disaster in a business can cause the company to gap down. If an event occurs outside the ASX trading hours, it is impossible for the share to adjust to the change; for example, a fall in the price of oil during the US trading session will result in a company such as Woodside Petroleum (WPL) gapping down once the market opens in
Guaranteed stops are one way to overcome the risk of a large gap severely affecting your account because the guaranteed stop gets you out even though there was no trade at the level you placed your stop at. You can also minimise the impact of a gap on your account by reducing your position size.
Indices, sectors or currencies are far less likely to gap than shares because they are a combination of more than one company, so the impact of a stock-specific event is less likely to create a gap. Sectors spread the risk over many companies, but still only trade during ASX trading hours, so gaps at open are likely to occur.
International indices and currencies trade up to 24 hours per day and opening gaps do not occur, with the exception of Monday morning. Currency and indices are normally closed on the weekend. Standard stop losses can be used and will be triggered once hit, with gaps very unlikely to occur.
Coming up next…
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