Personal Pro

Whenever you’re engaging in market trading or looking for investments in any market, knowing the risks and understanding how best to manage those risks is vital. Contracts for difference or CFD risk management is especially important for reasons we’ll explain in this article.

Before you start CFD trading, sit down and construct a strong risk management plan to help you ensure you’re able to maximise profits and minimise losses. Sticking to a risk management plan allows you to resist the temptations of trader psychology where emotions, cold feet, greed, and panic can cause you to make adverse decisions.

So how do you go about putting together a risk management strategy?

Understand the different CFD trading risks

First, let’s outline briefly some of the different CFD risks.

Market volatility

Financial markets in general fluctuate, sometimes with great volatility. A sudden drop or change in asset prices in a market, called gapping, is a risk that any trader takes no matter how sophisticated their forecasting tools and indicators.

Leverage risk

Despite only requiring a deposit margin (the money you need to post to open your position) to begin CFD trading, you’re still exposed by the full amount of the value of the underlying asset. Movement of the price in either direction will have an increased effect on your capital.

Your deposit isn’t the cap on potential losses

It is possible to lose more than your initial deposit. Maintenance deposits are required if your funds become depleted by decreasing price movements to the point where your cash on hand won’t cover future losses. If you don’t have sufficient funds you may experience an account close out.

Beware of holding costs

There are some costs in CFD trading that need to be factored in. The most prominent being holding costs if you keep your position open past the closing of the trading day and overnight. You will need to ensure your funds are sufficient to cover this expense as well.

Decide how high your risk tolerance is

Every risk management plan is dependent on the level of risk tolerance of the trader. Your plan should reflect not only whether you are risk averse or not, but the extent to which you are risk averse. While this might seem like an airy-fairy conceptual decision to make, if you skip it you’re likely to formulate a risk management plan that’s unrealistic for you to stick to.

Determine your amount of capital

An important initial stage of CFD trading risk management is determining how much money you’re aiming to profit and how much you are willing and able to lose. By arming yourself with this information you’ll be able to define your reward-risk ratio and better understand your CFD leverage as a result.

Calculate the leverage and margin of the trade

Part of the appeal of CFD trading is that you do not need the full amount of the value of the underlying asset being traded. Afterall, remember you’re not actually taking ownership of the asset but rather simply trading on the differences in price. Hence, the leverage your broker will use.

The amount of money that you’ll need for a specific CFD trade will depend on the asset and its volatility in the market. Based on the deposit margin you or your broker can calculate the most amount of money you can win or lose.

Risk vs reward

A risk versus reward ratio is a calculation that allows you to determine the relationship between the level of risk and the potential reward on a given trade. Simply put, the ratio is determined by dividing the reward by the risk. The more successful the trading strategy the higher the reward will be compared to the risk.

If a winning trade nets you $100 but a losing trade loses you only $50 your reward to risk ratio is 2:1. If the amounts are reversed your ratio is 1:2, which obviously isn’t very good. Sticking to your determined ratio is essential for successful, emotionless trading.

Profit factor

The profit factor calculates how many of your trades are profitable compared to how many are losses. You can do this by taking your gross successful trades and dividing it by your gross unsuccessful trades. This calculation determines the factor of your potential reward and gives you an indication of what you could possibly take away in profit.

Technical indicators

Technical indicators are used in CFD trading risk management as a way to identify and take advantage of a trend in the price movement of an asset. Riding the wave of a trend, which requires you to be able to spot the wave as it's forming, and not once it’s broken, is how you can apply your risk management plan and turn a profit.

Some technical indicators include:

  • Short term moving average
  • Long term moving average
  • Relative strength index
  • Fibonacci indicator
  • Bollinger bands

Utilising stop losses

Ideally every trader is looking to maximise profits and minimise losses. Utilising a trailing stop loss is one way of dealing with CFD trading risk.

The way a trailing stop loss works is that your stop loss point moves along with the market as it’s based on a percentage of the price level. So when the price moves up, your profits increase, and your trailing stop loss adjusts upwards accordingly. If the market suddenly turns, your stop loss is there to prevent the fall out at a higher level than it was earlier.

Through this risk management tool you can let your profit potential run while cutting as much of your losses as possible.

CFD trading risk in day trading

Most CFD trading takes place during a single trading day. Day trading however is when a position is closed at the end of the trading day in which it is opened. Risk management in day trading operates in much the same as intra-day trading but you need to bear in mind the daily ranges historically of the underlying asset of the CFD. Once you’re armed with your reward-to-risk ratio and you have worked out how much you can potentially lose, you need to then compare that against the historical range average.

Other considerations

There are a couple of other factors that you should factor into your risk management plan. Though not all of these are ‘risks’ per se, they are costs that should be considered.

  • Broker fees
  • Commission
  • Slippage in the price changing prior to trading