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Published On: Thu, Nov 15th, 2012

Important tips when trading CFDs

Trading CFDs is no doubt a great way for a trader to expose himself to a much larger amount of trading capital than that present in his trading account. This is because a CFD is traded on margin, i.e. the trader only has to put down a relatively small percentage of the amount of the actual trade.

Why is it then that many CFD traders lose money more often than they make money? The explanation probably lies in the fact that they don’t get the basics right before and during their trades.

Stop losses:

To trade CFDs without a stop loss exposes the trader to potential disastrous losses. On the other hand, trading with stop losses that are too tight usually result in a series of small losses, because the trader does not give the market space to ‘breathe’. A stop loss should be consistent with the time frame in which the trader trades. A good tip is to use the daily Average True Range to determine the stop loss for day trading. Study Fig 11.02(a) below to see the interaction between price volatility and ATR.

 

 

 

 

 

 

 

 

 

When volatility is low, the ATR will also be relatively low. When volatility increases ATR will likewise increase – and so should the level of the trader’s stop loss. A possibility is to set the stop loss one or even 1.5 ATRs below the current price.

Diversification:

Experts like George Soros might get away with specializing in one or more markets. For most retail traders that would eventually mean suicide. Rather spread risk over more than one industry and even more than one trading instrument, e.g. shares, currencies and commodities.

Money management:

No trader should ever risk a substantial amount of his or her trading account on any specific trade. Many successful traders have a rule not to risk more than 2% of their capital on any one trade.

Margin:

CFDs are traded on margin, i.e. the trader needs to deposit a certain amount of money which the broker requires in case ‘things go wrong’.

What is important to know here is that the margin on CFD trades is not fixed – it can increase dramatically if the trade starts going in the wrong direction. That is why it is important to leave enough funds in the trading account to make provision for potential margin increases.

A trading system

Any trader who bases his trades on ‘gut feel’, market rumours or ‘informed opinions’ from 3rd parties will most likely end up with more losing than winning trades. With trading it is imperative to have a system which determines when to enter into a trade, how much to trade and when to exit the trade – and it is vital to stick to that system consistently.

Stick to winners and let go of losers

The old adage of ‘let your profits run and cut your losses’ is as true today as when it was used the first time. If there is one single reason why many newbie traders fail it is because they cling to losing trades and cash in on winning trades long before they’ve reached their full potential.

The solution to this problem is to have a rule that states not only when a trade should be opened, but also when it should be closed. This could e.g. be based on a percentage movement in the price of the underlying or a trigger provided by a technical indicator. The important thing is never to base these decisions on emotions.

 

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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