Expert traders of CFDs must understand these products inside and out, which means building a deep understanding of the risks of trading CFDs. This will be the subject of this week’s CFD trading article in our short series.
Risk is a word you’ll often hear dripping off the tongue of experienced traders because it’s a vital component of investing returns and it’s central to everything a trader does, from deciding what strategies to use, to how many trades to have open simultaneously and how much capital to allocate to each trade.
Another point to consider is that many day traders lose trades as often as they win. They can only be profitable overall if the pound value of their wins outweighs their losses.
In this article we’ll look at risk from these angles:
- Capital / bankroll management
- Leverage & volatility
- Trade exits (stop-losses)
Capital / bankroll management
Bankroll is the term for your investable capital. If you are a professional investor, this could be a flexible figure that grows depending on your success and an increase in your department’s appetite for risk. If you’re an individual, this will be limited to the amount you can afford to risk losing through trading.
It almost goes without saying that retail investors should not engage in high-risk trading using money they cannot afford to lose. This includes money being saved for important events in the near future like buying a house or making loan repayments. Trading can be stressful enough without risking knock-on impacts on your quality of life if trades don’t go your way.
You should also remain aware that your performance may improve over time and you may make more mistakes in your first few weeks of trading. There’s wisdom in starting with a small pool of capital that will allow you to build your experience without risking your wider entire bankroll.
CFD providers are required by law to disclose the % of traders that lose money trading CFDs with the firm. The statistics quoted typically range from 70% – 80%, which gives you a sense of the risk of trading CFDs without controlling for risk and managing a bankroll prudently.
Bankroll management is about more than just treasury considerations. It also includes the critical question of how much of your bankroll should you risk with each trade.
Even a trader with a consistent advantage could run out of money due to an unlucky string of losing trades.
This sentence encapsulates why bankroll management is so key when trading CFDs, so it’s perhaps worth reading again.
It serves as a cautionary tale when deciding how much to risk on each position you take. The more you risk, the higher the likelihood that your bankroll will be exhausted by a series of loss-making positions. The smaller your trade size, the smaller your returns will be per trade, but you are increasing the likelihood that your overall returns will converge to your expected return.
As a trader with an edge, you want to operate like an insurance company. Rather than gambling the profits of the firm on the outcome of a single individual policy, an insurance company spreads its risk across so many individuals that it becomes indifferent to the outcomes of each policy. It knows that overall, its profits will align to the underlying price of each policy compared to its expected cost.
As a trader, you won’t have the luxury of being able to quantify or calculate your ‘edge’, as this will wax and wane from day to day, and may even remain elusive. But by spreading your risk over as many trades as possible, you are helping to protect your portfolio from bad luck. That’s why many day traders use a rule of thumb such as only risking 1% of the bankroll value on any single trade.
When trading a number of investments, you’ll need to keep an eye on the overall liquidity of your positions.
CFDs are highly liquid instruments because positions can be closed at any time during trading hours and their outcome is cash settled same-day (read more).
However, if you’re using a variety of platforms to invest, you may hold illiquid instruments such as:
- Privately placed corporate bonds
- Private equity (via crowdfunding, angel investing, or a collective investment vehicle)
- Fixed-term savings accounts
- Structured products (OTC)
Illiquid investments aren’t always difficult to sell, which can create a false sense of security.
When times are good, there may be ample offers on a secondary market to buy your private equity stakes, but these offers could dry up overnight if economic data indicates a recession is on the horizon. You may then be locked into a position indefinitely, with no ability to exit to limit losses.
You should always ensure that your portfolio includes an appropriate mix of liquid and illiquid assets that complements your own investment time horizon and your appetite for risk.
Leverage & volatility
CFD instruments are usually traded on margin, which means the trader gains exposure to a trading position while only offering a fraction of the position in cash.
This means that gains and losses are magnified relative to the investor’s own equity, which can lead to extreme gains and losses, including the potential to be ‘wiped out’ where the potential exposure on a single trade exceeds your bankroll.
Another point to consider is that when entering into a long position – the maximum loss from the trade is known. I.e. a £1,000 position to BP plc stock could result in a maximum loss of £1,000 in the event BP’s share price went to zero.
However, when shorting the price of a stock, your losses have no limit because there is no upper limit on how high a share price can rise. This subtly changes the risk-reward ratio between shorting and going long on an instrument.
Exiting a trade
One risk management technique is to use orders known as ‘stop-loss orders’ which are placed in advance and will close a position if the trade moves against you by a specific amount.
Stop loss orders are not guaranteed to work – they can sometimes fail to trigger in scenarios where the price of security skips past your trigger price point without ever being quoted at the stop-loss price.
Some brokers offer a sell order called a guaranteed stop loss order that will guarantee execution in exchange for a premium fee.
Trading with stop-loss orders could have a significant impact on your risk because you can ‘cap’ the negative exposure on any trade to try to engineer a pattern of asymmetric returns where losses are small whereas gains may seem to have no limit.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.