10 Golden Rules of CFD Trading
Hi everyone, today I’m going to cover what I believe to be 10 of the most important rules to follow when you trade CFDs. I know there are loads of similar articles, etc out there containing similar lists of rules but I thought I’d give you my spin on what I think are the post important things based on my experiences over the last few years. Ordering these was a little tricky also, different lessons learnt over the years would show some more important than others at different stages, but I’ve tried to put the most important ones near the top and worked down the list from there.
- Never Trade With Money You Can’t Afford to Lose
This one is fairly obvious but really has to be top of the list. Just like investing in shares, spread trading can be risky business, in fact given the leveraged nature of CFD trading, it is actually a lot riskier. You can, and most likely will, lose money on some of your trades, so therefore every time you open a new trade it is important to put in money you can afford to lose.
- Never Buy A Stock Just Because Someone Else Is
There are always people out there tipping this share or that share, websites, blogs, tv, newspapers, friends, work colleuges, etc, etc.. There is no harm in taking these tips on board but the important thing is that before you open a trade yourself that you have done your own research on the share in question. You need to be sure the share meets your own criteria for a trade and that you’re not just blindly opening the trade because someone else told you to or because you read about it somewhere.
- Take a Small Position
If you want your trading career to last any length of time worth talking about you need to preserve your capital. And the best way to preserve your capital is by managing your risk. And in my opinion the best ways to manage your risk are to take small positions (especially early in your early trades until you build up your trading capital) and to keep your stop losses tight (see point no. 4). CFD trading is not a ‘Get Rich Quick’ game and you should not be opening trades with the mindset that you are always going to be right and that you are going to make 1000’s of euro or pounds on each trade. That’s just not how it works. The best way to become a successful trader is to focus on making small but regular profits from your trades. One final tip on this one, if you do trade small and hopefully make some money, don’t start beating yourself up about what you would have made if only you had put on a bigger stake per tick, be happy with your winning trade, learn from it and try repeat it again.
- Always Use a Stop Loss and Never Move It
Next up, Stop Losses, the godsend of my trading life on many an occasion over the last few years! I’ve read and thought about some of the arguments for not using stop losses at all, but trust me it’s not worth it. You should always set one. And more importantly once you set it don’t fall into the temptation to move it if the share price starts getting close to it. I know from experience that there is probably nothing more frustrating than setting a Stop Loss at a certain level, watching a share come down to it and just barely take it out and then within a few hrs (or sometimes minutes) reverse straight back in the opposite direction, often moving to a price that would have made your initial trade profitable!
That said I have experienced way more examples where my Stop Loss came into play and helped limit my losses to that level as a share continued to fall well past what I had set my Stop Loss at.
I’ve also made the stupid mistake of moving my Stop Loss as the price got close to hitting it. Once or twice it worked out for me but more often than not I just ended up eventually closing out my position nursing a bigger loss than if I hadn’t moved my stop.
- Trade the Trend
This one comes up again and again but there’s a reason for that, it’s because it works. There are all sorts of studies, analysis and statistics out there which show that a rising share price is more likely to keep rising then reverse and start falling. Likewise a falling share price is more likely to keep falling then reverse and start rising. It’s only a very small statistical bias but it’s still a bias all the same and you should use it to your advantage. So when you open a trade always look at the daily chart and make sure that it is clearly trending in one direction or the other. If it is trending upwards, make sure you are opening a Buy trade. If it is trending downwards, make sure you are opening a Sell trade. Don’t try trade against the trend, you may get lucky but invariably you are going against what the wider market believes and what they are doing with their money.
- Never Try Catch A Falling Knife
This is another very important rule, whenever you see a share falling fast (because of some bad company news, results or whatever) there is always a temptation to jump in there and buy it. Sure everyone loves a bargain! Attitudes range from ‘The market has over reacted!’ to ‘It is sure to rebound tomorrow’.
The problem is that most of the time “catching these falling knives” as the professionals refer to them is not a bargain at all. In many cases big share price drops of 20% plus in a single day is just the first leg down in what often turns out to be a move towards much lower levels. There is no doubt that sometimes you will get a snapback or rebound in the share price almost immediately, but opening trades with this hope in mind is not good practice. Sometimes there may be a few days where the share rebounds somewhat, but usually before very long it will start falling back again and end up going even lower.
There are loads of recent examples of these so called ‘falling knives’, take any of our Irish banks or any major bank globally for that matter and look at its share price over the last 12 months and you’ll see falling knife after falling knife! Think of the amount of media commentary on the likes of Bank of Ireland when its share price fell below €10 for the first time in years, how it was a great bargain, then think of when it fell below €5 for the first time a few months later, or €3 not long after that, or even when it fell below a €1 for the first time…all the talk of this being the bargain of our lifetime…in the long run it may well turn out to be a great bargain but short-term the facts are that it continued to fall until eventually hitting a low of just 12 cent per share in March. The point of this example is to show you what is meant by trying to catch a falling knife, it will likely end in tears. No one can predict the bottom so the best trading approach in these kind of scenarios is to just trade the trend, if it’s falling, short it. If you think it’s a great bargain and want to buy it, wait until the market agrees with you and the price is clearly back in an uptrend. Don’t worry about missing out on not getting in at the very bottom.
- Know when you are Wrong (and Right)
Linked to several of the earlier rules (moving your stop loss, catching a falling knife, trading against the trend) is the idea of knowing when to get out. If you open a trade and it quickly becomes clear that you called it wrong, close it. Don’t continue to hang in there hoping the things will change and you’ll be proved wrong. If it is clear you made a wrong call then just close your position, you don’t even have to wait until your stop loss is hit, although if you have set your stop loss at a particular level for good reason then it may be worth letting it play out. The most important thing is not to move your stop so as to give your trade more time to turn round.
All the best CFD traders have losing trades. It was best explained to me before that you’d be better off having 5 trades where you lost €100 on 4 of them and made €500 on the 5th than having 5 trades where you made €100 on 4 of them but lost €500 on the 5th. In my own personal trading I firmly believe in this approach, I open lots of trades (for smallish stakes per tick) where I set fairly tight stop loses. I am happy (well maybe happy is not the right word…more accepting!) that several of these trades may get stopped out with small €100-200 losses as long as the ones I get right result in my making €500 plus.
Related to this point is the idea of also knowing when you are right. Sometimes when you open a trade and it is going really well for you, you are up a few hundred euro, it can be very tempting to take your profits and run. While it is very true that you’ll never go broke taking a profit on every trade, it is important to look at a trade objectively, just as it’’s important to cut your losses, it is equally as important to let your winners run. If you have opened a trade which is clearly trending in the right direction for you, resist the urge to close it out too soon. Often these shares can continue to trend in that direction a lot longer than anyone would expect. Certainly move your stop up as you go to lock in certain profits, but keep it at a level where the share still has time to move about a bit but ultimately continue its trend upwards or downwards.
- Always Buy Near Established Support
I plan on cover more detailed examples of support and resistance over the coming weeks but for now I just want to touch on it as part of these 10 Golden Rules. Support is one of the many technical analysis concepts and basically means that when you look at a chart for a particular share you will spot areas of support for the share price. Let’s say a particular share has generally being trading in a range of between €10 and €15 over the last 12 months. Every time the share comes down to the €10 mark, rather than continue to fall further, it moves back higher. €10 would then be considered an area of support for this share. The more often the share price rebounds of the €10 mark the stronger the support becomes. As a trader therefore you should be looking to buy (or go long) the share close to the €10 mark and you should be placing your stop close underneath it (let’s say €9.50). If you can open a trade at let’s say €10.20 a share, you are hoping €10 will again act as support and if the share price rebounds you would be looking to book profits near the €15 mark (the price that has acted as resistance in the past.
Related to this concept is the idea that when a share price does break through established support it tends to fall hard and fast (often seen by traders as a good shorting opportunity). The reverse is also true, if a share price can break through established resistance then it tends to move higher from there quite fast and this is often a good point to Buy (or go long).
- Know your Risk Reward Ratio
Throughout a lot of these rules we talk about managing your capital and managing your risk. Part of all this is the idea of keeping an eye on your Risk Reward Ratio whenever you open a trade.
- Learn From Your Mistakes
And last but certainly not least is the importance of learning from your mistakes. As mentioned above all good traders have losing trades, the important thing is that you learn from each one of them. What did you do wrong? Did you open the trade too soon? Was your stake too big? Were you going against the trend? Etc, etc…
And it is just as important to learn from your winning trades too, what did you do right, where you just lucky, etc, so that you can feed that knowledge into your future trades.
On this point one thing I would strongly recommend to all traders is to keep a log of all your trades. Overtime as you trade more and more you will forget your early trades and the lessons learnt from them. A spreadsheet will do the job nicely. For example in mine I track the following on each trade I open:
- Trade (name of share, index, commodity, etc and whether I’m Long or Short)
- Date (Date I opened the trade)
- Trade Price (Price I open the trade at)
- Close Price (Price I closed the trade at)
- Points Difference (Close Price – Trade Price)
- Stake (€ per tick)
- Profit / Loss (Points Difference x Stake)
- Notes on Trade (a few bullet points on how the trade went)
Overtime a spreadsheet or diary along these lines will become one of your most important assets.
So there you go, I hope these rules help somewhat. I am sure I’ll think of one or two more as soon as I hit Publish on this post! But sure 10 is a nice round number so we’ll go with that for now and if I think of any other important trading rules that you should consider following I’ll cover them in a later post.