Managing the Risks of CFD Trading

CFDs trading should be treated no differently to trading Shares. So in that respect it IS easy. Share trading for sustained profit is NOT easy. I am no expert on CFDs but here are my views, and thoughts to date to help or hinder.

Greed

I think the danger and pitfalls with CFDs lies in the ability to manage the gearing of capital plus the additional margin costs. Money and Trade Management become critical once gearing is applied. If Money Management is in place already and your trading system is profitable then CFDs are just a mechanism to gear your success to date.

For example, with 10k in the CMC account, you could limit yourself to 10k of CFDs i.e. same as direct shares. This is the safest way to start and allows you to overlook the risks of margin calls. Just manage your CFDs as you would shares (i.e. money and trade management - stop loss, take profit, and keep an eye on the time decay factor for a healthy rate of return - ROR). CMC charges daily interest on your portfolio hence the ROR factor.

I am of course assuming that you will always have a stop loss price to limit erosion of capital no matter what broker or derivative/commodity you trade.

With 10k you could also go long or short on say approximately 200k of BHP or Nokia share CFDs. DEADLY - not only have you geared to 95% (the max for these shares) but left no free equity in your account to cover the 0.1% brokerage, the daily margin interest charged (7.25%/365 of 200k = $39.72), or stop losses.

If the share price drops, it impacts your margin immediately. This is where a CFD or in particular a CMC Contract differs from a normal share contract and requires tighter money management.

In CMC your account is marked to market 24 hours a day, so you MUST have sufficient equity to cover ALL price movements of a share at all times.

So, you might ask, how do I keep on top of this detail and try to keep it simple?

Answer. Money Management and magical spreadsheets, apprentice trader style. Keep it simple and safe.

  1. Every Buy/Sell Order is followed through IMMEDIATELY with a Stop Order calculated using support / resistance, previous high/low or 5% of total purchase cost whichever incurs the least loss. I did use a wider stop on my first trade (7%) but decided this was too big. Trading books suggest 5-8% is a healthy range. e.g. 2 losses of 5% means 1 win of 11% and your square; 2 losses of 8% needs 1 win of 19%. Do some back testing and you will agree, a worst case % stop seems to limit losses as a default exit strategy.
  2. Assuming CFDs requiring 10% margin are used (i.e. 10 times gain/loss), maximum exposure is half of my equity. i.e. 10k equity allows one to hold 50k of CFDs using 5k margin. The other half (5k) is there to cover a worst case 5% stop loss (5% of 50k = 5k) on all trades. So now I don't have to worry about margin calls, just manage the trade as a normal share trade.
  3. I monitor active trades and will only add or increase positions if they are all in profit and my stops are now stop profits not stop losses.
  4. I am fine tuning the money management side and tracking equity based on target prices, current prices and all stops hit with slippage. The usual win/loss ratios and weekly cash flow charting are also done. I know exactly where I am and where I could be if the market works for me or against me.

Hope this helps as a starting point. I could go far deeper into the money management side as I am now working my account a little harder (since Easter) so need to track equity closely. I am trying to apply money management rules as detailed in Elder's book and Compton and Kendells Book, the latter is readily available at public libraries as is excellent for a beginner. It takes you through trading, indicators and ends up with a trading system including full details for a good money management system.