CFD Trading Using Stop Losses
- Making money in the markets requires a trader to predict the market direction and make trades that ultimately generate a profit. Because of this, many day traders develop the mindset that they have to be correct on most trades. This is wrong.
- We have read about stop losses, watched videos, even experienced paper losses on demo accounts. But they didn't hurt us then. You can tell a small child not to get close to a hot oven, but would he really learn, before he actually gets burned?
- In my opinion the most important thing to drill into one's head is stop loss stop loss stop loss...no matter whether investing or trading one needs a stop loss. I still remember that when I started out I had 20 successful trades in a row (seriously, not a single loss!), I thought I'd discovered the 'secret of printing money' and would never ever lose (no brains in a bull market). Well, when all 5 trades of mine started going against me (all longs, another mistake) I was too slow to realize how wrong I was. I hoped everything will turn up fine (it had before) and didn't cut my losses short (another grave mistake)...
- So again beware how fast the market can lose ground and be ready to cut your losses and look for other opportunities! As much as we keep hearing this, this is probably the most common broken rule. Most trading coaches and experienced traders suggest that we should keep our losses to a minimum while running profits. In absence of this the risk of ruin increases and as traders our first goal is to preserve our capital. Without a trading pot base we have nothing to trade with. So, when a trade goes against us, we should be quick to cut losses and on a disciplined basis.
- If you find it difficult to accept the reality that you may have been wrong on a trade, you will find it harder to close out losing positions. Instead, you will try to convince yourself that you may still be proven correct and that the trade may turn round and become profitable. There is a risk that subconsciously, you will only recognise evidence that supports where you want the stock price to go, ignoring evidence that suggests you are wrong. Once you accept that you won't get every trade right and that you don't actually need to be right each time, psychologically speaking you will be much better placed to manage trades effectively.
- One common trait of successful stock market traders is their ability to get out of losing positions quickly and without hesitation. In the classic book Reminiscences of a Stock Operator, Jesse Livermore (which most people in the industry regard as one of the biggest traders of all time) lived by this rule. Far too often newbies are tempted into moving their stop levels for fear of being stopped out of the market at the low or high. This is also about investor psychology; traders can be willing to cash in their profits early and take their losses late. A way to avoid this would be by having pre-determined targets in place before opening their trade and sticking to those targets.
- Do you have other investment ideas where you would put the money that you have conviction in? If yes, don't hesitate to sell and move on. There is no harm taking a loss from time to time. Markets change and even the most experienced traders will get it wrong – in most cases quite often. What looked good in the past may not look good in the future, and a good trader must be constantly on the alert. If you have multiple stocks in your portfolio then use your losses to offset one that you have gains on that you are done with as well. Net out the capital gains whenever possible. I do a LOT of soul searching in early December! :)
- I believe one of the most important aspects of trading is psychology, are your trades planned? You need to plan a trade then trade the plan... Let's take the case of a stock that falls 20%. Most beginner investors will wait for a bounce back rather than take the hit and bailing out. But this is a mistake possibly related to an emotional attachment to a company or story that has no place in the dog-eat-dog world of speculating.
- Every single trader has his own fair share of losers, that's part and parcel of the game, but what I like to think of is the 80/20 rule and that's that 80% of my profits come from 20% of my trades, for instance in March doing my forex trading I have suffered more losses than normal but my account is still up, it's because we are in a ranging market and my winners have been of the 20-40 pip variety instead of being able to run a few 100pip plus winners.
- Thus, when trading CFDs the use of stop-losses cannot be understated and most CFD providers will offer a whole host of different order types to help manage trading positions. Always use a stop loss and be disciplined should the market breach your exit level. Always use actual stop losses 'Mental stops' do not work. Losing over 10% on a trade may be of limited significance with physical shareholdings, however the geared nature of CFDs mean that this could result in a much larger loss and be especially damaging to a trader's collateral. So make us of stop losses...but I mentioned that already ;)
- Never average down a losing position. If a position moves against you get out and cut your losses. When it comes to trading, hope is a four letter word. Holding on to losing trades can also result in opportunity costs, as capital remains tied up in losing trades and better opportunities are missed.
- So never trade on hope. Think about how much you are willing to risk. Set your stop loss and keep to it, rather than moving your stop loss further away in the hope that the price will recover. One of the most common mistakes is for the market to move against your positions and for a trader to refuse to accept the loss (irrespective how small; ego playing here). It's like the short term trade that becomes the long term investment, it's like using charts because then it's the chart's fault, or using trading systems because you can blame them. As a consequence the loss becomes bigger and then the loss becomes even harder to gulp and the trader continues to refuse accepting it. This struggle continues until the loss is so overwhelmingly large that the trader has no choice but to finally take the loss. The problem with this is that a trader who loses 50 per cent of his original capital will have to make gains of 100% just to breakeven. Thus, if your goal is to make a gain of 20% a year, it is gonna be tough...So place hard stops immediately after entering a CFD trade. Stops should only be moved up to lock in gains, never down.
- Using limit orders allows you to automatically exit a trade at a pre-determined price, while a stop loss order protects your downside. Of course it is also a good idea to move stop losses as the market moves in your favour to lock in profits or utilise trailing stop losses to lock in gains. Note that stop loss orders are not guaranteed, as sometimes markets or shares gap overnight, which means there is an area within which your order cannot be fulfilled. Here, trades are done at the first available price in the market, so to avoid this risk guaranteed stops can be used. These ensure that you get stopped out at your chosen level no matter what happens, but for this protection a wider spread may be charged by the broker.
- Don't simply assume your trade exit point will be exactly where you have set your stop loss level. It is important to understand that a stop-loss order just provides a trigger point for the execution of an order. To varying degrees, 'gapping' or 'slippage' is common across all financial markets. If a sell stop has been placed on a long position, the stop-loss will be activated if price trades at or below the nominated stop level. From time to time, this can result in trades being executed a price that is less favourable than the nominated stop-loss price. This is known as slippage. In practice, this means that your stop loss will be executed at a worse price than you anticipated, which costs you more - depending on the market, sometimes - especially for volatile markets like commodities, substantially more.
- Every CFD trader's risk profile is different as is every share's risk profile. In general, the more speculative the stock, the higher the risk. As such, those CFD traders with a more aggressive risk profile, trading higher risk instruments should consider guaranteed stops to cap their downside risk.
- You should aim to keep maximum drawdowns between 20 and 25%. Once drawdowns exceed this level it becomes increasingly difficult, if not impossible, to completely recover.
- Be willing to stop trading and re-evaluate the markets and your methodology when you encounter a string of losses. When the inevitable psychological slump hits and the stock market seems to be conniving against you, it is usually best to walk away and take a break from trading. Come back afresh and stick to your trading plan. The truth is losing trades are inevitable.
- And lastly but importantly only trade with money you can afford to lose.
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