CFD Trading Risks and Stop Loss Orders


Q.: Are there any risks with trading CFDs?

A: The power of leverage can work against you just as quickly as it can make you profits. So if you get the markets wrong, always remember to apply adequate risk management strategies. Both losses and profits may accumulate up to 10 times faster (and more according to the leverage multiplier) than non-leveraged positions when using the full leveraging opportunities of CFD's. Of course, the leverage is only there if you want to use it. If you have USD 10,000 in your account and your only open positions are USD 10,000 of CFD's, then you aren't using any leverage.

Many retail traders in fact lose from panic buying and selling and this is where psychology (fear and greed) comes in. Stocks can go up over 30% in a day and some people jump in fearing that they will miss the boat. However, stocks that soar up 30% in a day from news are likely to fall back the next day on profit taking and may even end up back to the price before the announcement.

Financing costs on long positions can also add up, just as they would be if you undertake traditional margin trading. So you should always keep an eye on the costs associated particularly with maintaining a bought position for a longer period of time. Short positions incur no financing charge.

 

Q.: What is a Stop Loss Order?

A: This is an instruction to deal at a less favourable level than the current price and is usually used to limit the potential loss on an open position. Seasoned traders will set a stop on all their positions to automatically limit the downside risk should the market move against them. All brokers will allow you to place stop losses on your positions so you can set the market level that you'd want to exit the trade at. As well as protecting you from spiralling losses, they also allow you to bank profits and keep your position open if things are still looking good; you do this by re-assessing your stop and moving it above the entry level, locking a profit in the process. When shorting the opposite applies; it is simply a case of moving your stop down to track the fall. Stop loss orders are free to place with your broker. When a stop is hit your provider will do their best to execute your order at the best possible price nearest to the stop loss level. But usually you will get a price a tick or two from your stop loss, depending on how a liquid market you are in. This is called slippage. It is no big deal and should be factored into your trading plan anyway.

Q.: How important are Stop Losses?

A: Stop Losses are an essential tool for successful traders, even more so when trading on margin. They are generally underused by private investors who do not take advantage of one of the most important investment tools available.

Q.: What types of orders are available?

A: To summarise [Source: GFT]

  • Market Orders - A market order is a request to buy or sell at the current market price, guaranteeing execution, but not price. As such, a market order may be filled at a different price than the price submitted by the customer.
  • Guaranteed Stop - Guaranteed stop orders guarantee execution at your specified price. However, this order type requires an extra charge and is not available for all markets. For instance, if the current price is 242 and you placed a guaranteed stop loss at 240 but the next available price in the market was 235, your order would still be executed at 240.
  • Stop Orders - A stop order is used to enter or exit the market at a particular price. However, depending on market volatility, execution and price are not guaranteed. Stop orders are commonly used to set an exit point for a losing trade to try to limit risk.
  • Limit Orders - A limit order specifies that a trade must be executed at a specific price or better. Traders typically use limit orders in attempt to capture profits and exit a position; however, they can also be used to enter a position.
  • Parent and Contingent (If Done) Orders - A Parent and Contingent order allows you to easily place an entire trade, including stops and limits, in just one step. The contingent orders will not be filled until the parent is executed, allowing traders to set up the entire trade, including entry, exit and risk management, based on specific market prices. Parent and Contingent Orders are often set as OCO orders (linked orders) so that when one of the contingent orders has been filled, the other is automatically cancelled.
  • Stop Sell - This order would be used if you want to sell below the prevailing market price. Usually used in a long position since you may wish to limit your risk by selling out if the price falls to a certain level. However, sometimes this order is also used to enter a short position.
  • Stop Buy - If you have an open short position you may wish to limit your exposure by buying in if the price rallies to a certain level. This would involve using a Stop Buy Order. This order would also be used to open a long position when the price rises to a pre-determined level.
  • Limit Buy - This order can be used to enter a new position or to realise a profit from an existing position. A Limit Buy consists of an order to buy below the prevailing market price and such orders are suitable to close profitable short positions or to open long positions once the price has fallen.
  • Limit Sell - Should you wish to sell short at a certain level at a higher price than the current price, then you would use a Limit Sell order. This order is also used to close profitable long positions.
  • GFTD - Good for the day. This consists of a limit order which only runs for one trading day. At the end of the day, if the order has not been executed, it is cancelled.
  • GTC - Good till cancelled order. This is a limit order which you place once, and keeps on running from one trading day to the next until you either cancel it or change it.

Note: Automated orders are always useful but stop loss orders with margin products like CFDs are crucial as they are the only way to limit potential losses while the limits are a good way to take profits so as not to lose out on any gains.

Q.: What is the difference between sell Limit and sell Stop?

A: A limit order is an order to buy or sell at a specified price or better. A good way of using them is to automatically take profits by closing a position if the market reaches a pre-determined price level or alternatively a limit order can be used to buy into a market should this decline to a point where an attractive entry point can be spotted.

A stop order is an order to buy or sell at the market once a specified price is reached.

A stop limit order is an order to buy or sell at a specified price or better but only after the specified price has been reached.

Q.: In each of the following, what kind of order do I use?


1) Buying shares: XYZ is trading at $10. If it drops to $8, I want to buy. Stop or Limit?
2) Buying shares: XYZ is trading at $10. If it rises to $12, I want to buy because I think it has started a breakout. Stop or Limit?
3) Selling shares: XYZ is trading at $10. If it rises to $12, I want to sell. Stop or Limit?
4) Selling shares:XYZ is trading at $10. If it falls to $8, I want to sell. Stop or Limit?

A: Ok to address your query -:

  1. Buy - Limit @ $8 (executes buy when XYZ falls to $8).
  2. Stop I believe but I am not sure you can set this order up automatically.
  3. Sell - Limit @ $12 (executes sell when XYZ rises to $12).
  4. Sell - Stop @ $8 (sells position when XYZ falls to $8).

Q.: What are better - market or limit orders?

A: Limit orders are usually better 99% of the time. Market orders allow you to purchase a security at the ask price or higher. Market orders should be used if you need to get into a stock immediately. Limit orders should be used only if you want to pay a certain price. Remember just because you set your limit order doesn't mean it will get executed.

Market Orders should be used on liquid stocks with tight bid/ask ratios.

Limits Orders should be used if you want a specific set price but aren't concerned if the order doesn't get filled. If you put your limit price in at the bid or lower it will usually work out in your favour.

Q.: On a fast and liquid share what would be the good, the bad and the ugly of placing market orders and same question for limit orders?

A: On a fast and liquid stock, I see no disadvantage of placing a market order. On a limit order, you might in some cases miss your entry fighting over a penny or two per share. The reason why a stop-limit order can get passed over is that the price moves past your limit price so fast the order does not get filled.

Q.: But how can you place a stop-order so that it becomes a market order?

A: That's simply a regular stop order. That's how a stop order works - it becomes a market order when the price is hit.

Illustrating the Different Type of Orders

To Summarise:
A stop-limit order becomes a limit order when it is hit.
A stop order becomes a market order when it is hit.

The difference is that with a stop order, you are basically saying 'give it to me now no matter what,' but with a stop-limit order, you are saying 'give it to me at this price only.' On some platforms, it's not called a stop-limit; rather they just refer to it as a stop with a selection where you can either choose to get filled 'at best' (a stop order) or you can get filled with parameters (a stop-limit order). By parameters, I mean where it states something like 'fill only if the price is within this many pips of the price on the stop'.

Summary of Pending Orders

This is a client's instruction to the broker to buy or sell a share at a pre-determined price in some future date. Usually, these kind of orders are used to open a CFD position provided the future quotes reach a pre-determined level. There are 4 kinds of these orders:

  • Buy Limit - an instruction to buy given that the future 'ASK' price reaches the pre-determined value. In such cases the present market level is higher than the price of the order being placed. Buy Limit orders are commonly used in expectation that the asset price, having fallen to a certain level, will increase.
  • Buy Stop - an instruction to buy given that the future 'ASK' price reaches the pre-determined value. In such cases the present market level is lower than the value of the order being placed. Orders of this type are usually placed in anticipation of that the security price, having reached a certain level, will keep on increasing.
  • Sell Limit - an instruction to sell given the future 'BID' price reaches the pre-determined value. In such case the present market level is lower than the price of the order being placed. Sell Limit orders are usually used in expectation that the asset price, having increased to a certain level, will retrace back.
  • Sell Stop - an instruction to sell given that the future 'BID' price reaches the pre-determined value. In such cases the present market level is higher than the price of the order being placed. Sell Stop orders are commonly used in expectation that the asset price, having reached a certain level, will keep on falling.

Orders of Stop Loss and Take Profit can also be attached to a pending order. After a pending order has triggered, its Stop Loss and Take Profit levels will be referenced to the open position automatically.

Q.: What is an 'If Done' order?

A: If Done orders are sometimes referred to as Contingent Orders. This is similar to an OCO - an if done order links two separate orders together so that once the first order is executed the the second one is automatically entered into. If Done orders normally consists in automatically setting up your trading system to enter a stop loss order after your initial buy or sell order is executed. It is best for traders who are not able to check how trades are progressing during the day. So an 'if done' order automatically places a stop loss order into the market at the same time as your buy or sell order. This would only kick in if the initial order is triggered and means the profit taking and stop loss is all fully automated. Suppose, for instance that Next (London: NXT) has opened the trading session at 1150 pence but you are not able to follow the market during the day as you have to attend to other matters. So you decide to place a cfd order to buy 10,000 NXT CFDs at 1100 if the market retreats to that level but your resistance/support analysis indicates you that 1100 is a past support level long term. Concurrently, you set an 'if done' order so that it acts as a stop loss should NXT keep falling to the 1050 level. A few hours later the market drifts lower and your buy order is triggered at 1100. At the same time your stop loss automatically comes into operation at 1050 limiting your potential downside - quite effective really.

Q.: What is an OCO order?

A: OCO stands for 'one cancels the other' - this is a type of order which actually links two separate orders with the execution of the first order automatically cancelling the other order lined to it. In other words this is when you submit two orders in the market at the same time, usually consisting of a 'take profit order' and a 'stop loss order'. Continuing on the 'If Done' order example described above there are two possible outcomes. The market doesn't hit your 1050p stop loss level and rallies to 1250p (we assume this is your take profit target). But you aren't able to close this position if you are at work, say and don't have access to a computer workstation. The 'One Cancels the Other' takes care of this because should your 'stop loss order' be executed the 'take profit order' is cancelled. On the other hand if the 'take profit order' is executed, the 'stop loss order' is cancelled. So in both instances you are covered and the trade didn't require you to keep monitoring it.

Q.: What are linked stop loss orders and linked limit orders?

A: A linked stop loss is a kind of stop order that is used to limit the risk of a market moving against a current open position. Should the open position be closed, say by an opposing trade or order activation, then the linked stop loss order ceases to exist.

A linked limit is a limit order that is tied to an open position. If that open position becomes closed for any reason then the linked limit order will be automatically cancelled.

Q.: What is a Trailing Stop?

A: Trailing stop loss orders are designed to automatically follow a pre-determined distance behind the underlying market as a stock moves higher, but then don't move when if falls back; in other words stop-loss positions are reset as the price moves. They serve the purpose of locking in gains and to sell the holding should the share retrace by the full specified amount. For instance, suppose you buy a stock at $1 and set a stop-loss at 90 cents - you are limiting your loss to 10 cents. If the stock's price rises to $1.10, your stop-loss is reset at $1 still 10 cents.

A trailing stop works best when a share is trending upwards but you need to take into consideration the intraday volatility. For instance, if a security priced at 150p tends to move within a 5p range during a typical trading session, then setting a 147p price lock would likely trigger the stop loss before the close. Trailing stops can be very useful and effectively allow you to run positions without having having to be in front of a screen.

Q.: What is an Iceberg Order?

A: Iceberg orders offered by some CFD brokers like IG Markets allow for large single orders to be split into smaller tranches for the purpose of of camouflaging the actual order quantity. You are charged commission on the total size filled on iceberg orders (not per tranche), as you would be with a standard limit order. Standard commission rates also apply, there are no extra charges for using the iceberg facility.

Q.: Where should I place the stop loss?

A: It is always right to control the downside of any trade - especially with leveraged trades you don't want to turn into a long term investor. Where to place the stop levels depends on several factors. First, how much are you willing to risk on a trade - for instance if you can only afford to lose £1000, then you would place the stop level at a point that only loses this much. Other factors to take into account are your trade size and the volatility of the underlying market you are trading. For instance if you trade 10,000 CFDs on BHP Billiton plc, if you wish to limit your losses to £1000 you would set your stop loss just 10p away, however setting a stop loss level this tight is no good if BHP Billiton plc moves on average 50p every day. So to account for this volatility it would be wise to trade a lower size like 500 CFDs which provides you with a cushion of 200p.

Q.: Shouldn't a trader stick to his opinion?

A: No, definitely not. An analyst or some kind of guru has to stick to it, but a trader should have no opinion. The stronger your opinion, the harder it is to get out of a losing position. So accept that if you're wrong - you're wrong! Accept it before it gets expensive!

Q.: How important is risk management?

A: Risk management is critical to succeeding in trading. Professional traders stress the importance of understanding risk management - it is one of the keys to success.

Risk management is the part of trading that dictates how much of your capital you will risk. It is one aspect of your trading that you can control. Think about that. It is also a means by which to maximise and optimise your reward factor. Risk management has many other very important aspects, including trade position size which is key to effective capital management and needs to be well understood.

In fact debate occurs over whether risk management is more essential than a trading system/method. There are many successful traders, all with totally different trading systems that are either fundamental or technical, however most agree on the importance of preserving your capital, i.e. risk management. The importance of understanding the numbers cannot be overstated.

Risk management offers an objective look at your trading results. It is mathematical and speaks the truth at all times, confirming the reality of your trading actions. It can therefore help you to improve your trading results. Breaking down your trading into mathematical units shows you where the strengths and weaknesses are in your trading system. It makes it simpler and easy to understand.

Risking no more than 2% of your total capital per trade is a standard starting point when setting up your risk management plan. Experienced traders can trade with risk levels between 3 - 5% while some more adventurous and confident traders (gamblers!) trade with a 7 or 8% risk level.

Once you have decided your risk level you can work out your trading size. For instance if your trading fund is $10,000 and you have decided on a risk level of 2% then your trading size would be $200. This is the maximum amount you will risk on each trade (referred to as the risk amount).

2% per trade risk formula.

Account size x 2% = risk amount per trade

$10,000 x 2% = $200 amount per trade

Risk management is understanding your risk and reward - how much am I willing to risk to achieve a result? This in itself is an emotional decision that must fit your risk personality and risk parameters - what is my trading style? what are my goals and how am I going to get there?

Q.: Expert traders recommend a 1% or 2% stop loss rule of your total pot (per trade) - but how do you determine the stop loss level?

A: Ok - I can answer that...

If you have a 50K pot and want to buy XTA the first thing you do is work out your stop. Let's say you don't want to lose more than 15p (just an example).

1% of 50K is £500. So your 15p loss has to equal £500. You would therefore buy 3333 shares.

Loss is £500. To get to the 3333 you simply divide the loss you are willing to accept by the stop loss. £500/.15= 3333.

Q.: But stop losses don’t guarantee a get out do they? If the market tanks or skips past your stop you can lose a lot right?

A: An ordinary stop loss will not guarantee you get out and if something happened overnight it definitely would not save you. But if you ask for a 'guaranteed stop loss - you are guaranteed to come out at the set stop loss whatever happens. The only problem is they charge you extra spread for having the comfort of that so if you did a guaranteed stop on every trade it would cost you quite a bit over time...so you have to decide whether to go for ordinary or guaranteed stops...This is one of the advantages of using a market maker instead of going direct access - market makers are able to offer you guaranteed stop losses which do not exist if you deal direct in the market.

Q.: What is the difference between stop losses and guaranteed stop losses?

A: A regular stop-loss means that the cfd broker will take a customer out of a losing position on a 'best efforts' basis once a particular level is reached. Your broker will do its best to close it, but market 'gaps' can cause problems. This is where the market leaps up or down suddenly, leaving the CFD provider unable to close your position until the price has fallen beyond your stop-loss. e.g the stop loss may be at £1.50 per share, but the cfd broker is only able to sell the position at £1.45.

A 'guaranteed' stop loss means that the customer will be taken out of his position at exactly the level specified. There is a small charge to place a guaranteed stop loss, and you may only be able to place a guaranteed stop loss at the time of opening a trade. So a guaranteed stop loss is exactly that, guaranteed to be executed at your set level with no slippage. Perhaps I should illustrate this with an example on RIO stock to make this point clearer -:

Monday: I decide to buy 100 RIO-cfds at $60 Stop Loss at $55, Guaranteed Stop Loss Order at $55 (Risk = $500 + comm + costs).

Tuesday: Price moves up with market and when it reaches $66, I move the Stop Loss up to $61 and the Guaranteed Stop Loss Order to $61. As the Stop Loss orders are above the buy price a small profit is 'locked in' or is it?

Tuesday evening and news that BHP is withdrawing the bid breaks. RIO shares tank 30% in London overnight.

Wednesday: Rio opens at $41 your Stop Loss Orders are triggered and the broker executes the sell order at 40.90. Your Guaranteed Stop Loss Order is executed at $61.

The normal SL creates a loss of (60 - 40.80)*100 = $1920 + costs.

The Guaranteed Stop Loss Order creates a profit of (61 - 60)*100 = $100 less costs.

This is a difference of $2,000.

At the end of the day please note that it is your responsibility to understand how your broker/provider executes your orders. You need to understand the advantages of the GSLO and the extra costs that are involved for this service vs. the routine stop loss.

Q.: Is using Guaranteed Stop Losses worthwhile?

A: The problem with Guaranteed Stop Loss is the added costs, which can be significant and can add up if you extend the guaranteed stop expiry or change its distance. The positive is that it forces you to enter a stop loss when you place the trade, and it GUARANTEES your stop loss level!

What does a GSLO achieve?
1. A steady extra income stream for the CFD provider (= a steady extra drain on your capital).
2. It alerts the CFD providers to where you place your stop.
3. It puts your stop in the market where it can be hunted down.
4. It will result in the CFD provider giving you more margin to play with.
5. In return, you get protection from black swan events.

The insurance analogy is an apt one - you're insuring yourself against the possibility of a position wipe-out or slippage which you cannot tolerate. My contention is that it may well be more profitable in the long run not to pay for the insurance, but to accept the fact of the occasional black swan event in trading.

Do you (or I) know the odds of a black swan event? Nope. I'll bet, though, that the CFD providers do. Since they are nothing more than professional bookmakers on financial markets, I'll also bet you that they are the ones that net benefit from GSLOs, not us - just as insurance companies profit from selling insurance. Why else would they offer them?

The last time I checked with CMC Markets I was told their guaranteed stop loss (G.S.L.) orders can only be placed at a minimum of 5% from the market and they are quite expensive. Think about it most CFD margins are at 10% and if your guaranteed stop loss is hit, voila, there goes 50% of your outlay - not very good money management. At 5% margin you lose the lot!

There are times when a guaranteed stop loss is in order, example - shorting a takeover target, but to use one every trade is crazy when you look at the BROKERAGE that you are paying.

Q.: When might the use of a Guaranteed Stop Loss be considered?

A: Occasions when GSLO's should be considered;

1. trading stocks involved with announced Merger and Acquisition bids.
2. trading stocks over earnings, news events, AGM's.
3. trading over weekends in highly volatile conditions.
4. trading overnight in highly volatile conditions.
5. shorting stocks that have gone so low that there are potential takeover targets.
6. pyramiding aggressively as trend develops, position value becomes large, guaranteed stop loss level lowers margin which can be used elsewhere.
7. trading commodity CFDs.
8. trading stock CFDs in risky exchanges, Russia, China, India etc.
9. gambling with no money management.
10. any time that you are worried by the risk.

Q.: If I put an order to buy 600 shares at $1 and the order is executed in 3 parts of 200 shares...do these 3 partials executions count as 3 opening positions or only 1?


And if I sell these shares today do they count as 1 or 3 trades?

A: First answer: the 3 partial executions should count as 1 if they are executed on the same trading day (if they are executed in parts on different days they may be considered as separate orders by your broker). Second part to your answer: One.

Q.: Do brokers charge for modifying/cancelling orders?

A: No, brokers don't usually charge to modify or cancel orders. Note however that once an order is partially executed the commission charge applies. If, after an order is partially filled, you choose to modify it then it may be treated as a new order by your broker. If any part of that new order is filled you will incur another commission charge. Also, if your CFD order is part-fulfilled on different trading days (i.e. for instance the market closes but your order is only part-fulfilled and the next day the remaining batch is filled) you might also be charged separate dealing fees.

Q.: Can I amend stop loss orders when the market is closed?

A: Usually most brokers won't allow you to modify existing orders out-of-market hours. This is because your current orders might be used to make up your margin requirements and as such it won't be possible for clients to change them when the markets are closed.


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