Risks of Trading CFDs and Stop Loss Orders

Understanding the Risks of trading CFDs

Trading CFDs involves considerably more risk than ordinary share dealing and because of this will not be suitable for everyone. Those considering opening a CFD account would be well advised to consider the potential pitfalls, the most significant of which comes from trading on margin. This has the effect of multiplying relatively small moves in the underlying and as such will magnify both profits and losses. For example, trading on a typical margin balance of 10% has the effect of gearing up returns by a factor of 10 times so that a 5% adverse movement in the underlying market would wipe out half the deposited funds.

Contracts for Difference: Volatility Risk

The risk is exacerbated in particularly volatile markets that are subject to sudden and dramatic price moves. When trading individual equities or commodities for instance it is particularly important not to take too big a position. Traders who ignore this could find that adverse price movements give rise to substantial additional margin calls at short notice. If the funds can't be produced in time then the trade may be closed at a loss with the client legally liable to make good the resulting deficit. The worst-case scenario when trading shares is that they lose all their value thereby rendering the investment worthless, the upside being that the loss cannot exceed the stake. A CFD in contrast creates an additional contingent liability since the potential losses are not confined to the initial margin and may require additional capital to make up the shortfall.

The onus is really on the
trader to appreciate the risks and
to adopt a disciplined approach
to control them.

Getting Locked in

Another easily overlooked factor is that under certain trading conditions it may be difficult or impossible to liquidate a position, the prime example being when trading is suspended. It should also be remembered that CFD transactions are not undertaken on a recognised or designated investment exchange. They are over-the-counter derivatives that take the form of an agreement between the client and the provider and as such can only be closed with that same provider. Traders who find themselves over-exposed and having to exit a position may find the spread widen against them in response to the unfavourable underlying market conditions.

The Importance of Stop Losses

The onus is really on the trader to appreciate the risks and to adopt a disciplined approach to control them. There are several ways to do this in practice, the most obvious being to de-gear the positions by depositing more margin. The key however is always to use stop losses. If these are set at appropriate levels then any potential losses should be sustainable. Despite these measures CFDs remain high-risk and nobody should trade them unless they fully understand the nature of the transaction and what is at stake.

Types of Order

CFD providers now routinely support a range of sophisticated orders that are designed to help clients manage their positions. Perhaps the best known of these are stop orders. These can either be used to enter the market at a lower price than is currently available - a stop entry - or to limit the loss on an open position, the so-called stop loss.

A trader with a long CFD position would set a stop loss sell order below the current market price to automatically trigger a sell instruction should the price fall to that level. Most traders agree that the risks make it essential to use a stop loss, but that still leaves the issue of where best to set it. A good stop should not be too tight so as to close out a position prematurely or too wide so as to expose the trade to excessive risk.

A normal stop-loss order is only triggered if the market price matches the specified level of the stop, with the trade then automatically going through at the best price prevailing in the market. In effect the stop-loss sell turns into a market order as soon as the exchange price hits the stop level. These orders are free and will generally suffice. However the risk is that in a volatile market the price could gap well past the stop resulting in a bigger than anticipated loss. Because of this, the majority of providers now offer the alternative of a guaranteed stop or 'limited risk transaction'. These instructions have to be placed when the position is first initiated and, as the name implies, have the effect of ensuring that the order is executed at the requested price - even where the market gaps past it such as in the case of a very sharp overnight move.

For instance if the futures market opens with a gap against your position, a normal stop-loss order will most likely not be filled at the price you specified. The term used in the industry is "slippage" and it can hurt if overnight markets become volatile. A guaranteed stop on the other hand will be filled at the price you specify, even if the underlying market never trades that price. In effect it is like an insurance policy against a catastrophic event and for that reason CFD brokers charge a fee for using it, but it is money well spent for anyone concerned about market and account risk.

Guaranteed Stops and Limit Orders

Guaranteed stops are only available on certain indices and leading shares. They have an associated minimum stop level that may, for example, be no closer than 5% below the current share price. There is an additional fee levied for these orders that is really akin to an insurance premium. This is charged when the transaction is opened and will either take the form of extra commission or, in the case of an index, a premium on the spread of maybe an extra three or four points. The margin requirement is also altered to reflect the amount that would be lost if the stop were triggered. Traders are left with the decision of whether the risk of an index or blue chip gapping past a normal stop justifies the extra cost.

Equity traders are likely to be familiar with limit orders and these can be used in the same way with CFDs. In particular they serve to enter the market at a requested level that is more favourable than the current price, with the trade triggered if the mid-price of the live quote reaches the stipulated amount. For example, with the FTSE 100 quoted at 5040-5044 a limit order to buy could be placed at 5020 or a limit order to sell at 5065. These orders may be 'good for the day' or 'good until cancelled'.

If Done and Contingent CFD orders

There is a general move among CFD providers to offer more sophisticated order types that essentially represent a first step towards programmed trading. An 'If Done' or 'Contingent order', for example, is linked to an existing pending order - most commonly a limit or stop order to open a position. The 'If Done' order would lie dormant until the initial stop or limit order had been filled, at which point it would kick into life as a pending order awaiting execution.

A one-cancels-the-other (OCO) order takes things a step further. This commonly consists of a stop-loss and limit order placed either side of the prevailing market price and is used to close an open position.

For example, with a long position a stop-loss order would be placed below the market to limit the loss, and a limit order would be placed above the market to take profit. The effect of the OCO is that when one order is executed, the other is automatically cancelled. Some providers even offer the variation of an 'If Done OCO' order. This comes into play if the opening trade is made, setting both a stop and a limit to establish a price target with a maximum allowable loss.

 Hedging Exposure on CFDs