CFDs offer big potential rewards. You can guard against the risks if you pay attention to history.
Looking back it always seems much easier to see what you should have done. A bit of 20/20 hindsight and you wonder why at the time, everything seemed so different. Only with hindsight could you predict the market, make those fabled profits and eliminate the risks from your trading. Sadly, in the real world hindsight is there to remind you not to make the same mistakes again. But you can tap into the power of hindsight and learn from your trading mistakes. With a little research you can follow the less costly route and learn from other people’s mistakes.
For instance, many investors still do not set stop losses on accounts and in many cases the broker has to insist on stop losses to limit a loss. So learn from those who have suffered the consequences of not setting a stop loss or guaranteed stop loss and set one on each of your trades.
Remember, however, that a simple stop loss does not necessarily mean what it says. For example, if the share or index breaches your stop loss, then your order will be executed at the next available price at the time of dealing. This may mean the order is executed at less than your stop loss price in the case of a long position, or more than the stop loss price in the case of a short position. In other words, if you specified a stop at a given price, and a sudden downturn leapfrogs your trigger price, your loss will not stop where you thought.
Turning costly hindsight into profitable foresight
A way to learn by the miscalculations of others is to use a guaranteed stop loss. As it suggests, this is a stop loss order that is guaranteed to be executed at the price you specify. Even if the price of the underlying share or index makes a sudden movement and never actually trades at the price you specified, your position will still be closed at your chosen price. This may not be the case with a simple stop loss.
“To understand all that has gone before in the world of CFDs you need to understand its origins. It all started way back in the centuries-old commodities market, which itself took shape in the trade fairs of the Middle Ages”.
Services such as Hargreaves Lansdown CFDs may limit this service to telephone trades on selected stocks or indices. You also pay a small premium for the guaranteed stop loss facility when placing the deal, but many would consider this a minor price to pay compared with the cost of an unpredictable loss.
The benefits of using a guaranteed stop loss are demonstrated by looking at the following example provided by Hargreaves Lansdown, which is based on a scenario that actually happened.
A trader opens a long CFD position by buying 5000 Marconi shares at a price of 250p and decides to place a guaranteed stop loss order at 220p. The total contract value is £12,500 with an initial 10% margin of £1250.
Following a profit warning from Marconi trading is suspended. The share price re-opens at 115p; this is 135p lower than the price you bought at. Technically the shares never actually traded at 220p but, as the stop loss is guaranteed, the position you held is automatically closed at 220p. The contract value is now £11,000 and you have limited your loss to £1,500.
If you had not specified a guaranteed stop loss and had closed the position at 115p, your loss would have been £6,750 – more than two and a half times your initial deposit. This simple example does not include details of any charges, but does highlight the advantages of placing a guaranteed stop loss order.
To understand all that has gone before in the world of CFDs you need to understand its origins. It all started way back in the centuries-old commodities market, which itself took shape in the trade fairs of the Middle Ages. Merchants who brought products and livestock to trade soon evolved their business into a sample-based sale in which buyers and sellers struck deals based on the standard of mutually approved samples.
With the proliferation of new supply sources and product types over the ages it became necessary to concentrate materials management in those countries and cities with the strongest economies and infrastructures. Soon brokers, or agents for sellers, were also required to keep the trade in motion. Naturally enough, the first commodity trading centres were situated in seaports, or other conveniently accessed inland centers of distribution. The oldest of the structured inland markets, the Chicago Board of Trade, was founded in 1848 at the hub of the mid-west railroad network and here in Europe, London became the recognised centre of trade.
Once this mode of trade became established, the concept of buying and selling without seeing the actual product itself could be actively developed to expand the potential of profit in trade. A second step was the introduction of dealings for delivery and settlement on arrival of a ship into a port, and the third was to set dates in the future when the goods could reasonably be expected to be in a particular warehouse at a particular time of arrival.
Of course, the pitfalls in this trading were enormous and what was needed was reliable information to keep the market ‘honest’. There are many recorded instances from the early days of this kind of trading of ships being reported sunk, or having arrived when they hadn’t, or in many cases, a whispering campaign was started to discredit the quality of the goods being shipped so that someone would benefit from the fall in price.
Knowledge is power – and money
Thankfully, this problem has been all but eliminated from modern trading and reliable information is easy to come by. Many brokers will offer information for you to keep on top of your investment strategies and keep your portfolio on the right track, and one lesson to learn from history is to get reliable, timely and above all accurate information. Another lesson taught by hindsight is not to rely on a single source of information. Always obtain information on a stock from at least three sources. That internet chat room that gives investment tips should not be your market gospel.
Margin trading is possibly the biggest reason that investors move into CFDs. Again, hindsight teaches us important lessons about using margins, particularly because many investors who trade on margin overstretch themselves and end up with a huge portfolio that they are unable to cover should the market turn against them. The lesson from those who have suffered such a loss is to keep some cash in an emergency reserve fund.
Margin trading with CFDs means you can increase your purchasing power tenfold. Typically you will pay between 10% and 25% of their actual value. You also pay no stamp duty, unlike with share purchases, because you never actually own the shares. But you do pay capital gains tax on any profits, as you do with normal share-buying. CMC explains margin trading thus: ‘When trading on margin investors are asked to deposit a small percentage of the overall cost that would be required if they were to purchase the equivalent shares in the physical market. Even though the CFD investor’s outlay is small in comparison to the equivalent physical trade, the investor will still be exposed to the same potential profit and loss. This means that your potential return on investment is magnified.’
“Even though the CFD investor’s outlay is small in comparison to the equivalent physical trade, the investor will still be exposed to the same potential profit and loss. This means that your potential return on investment is magnified.”
Margins do vary, so another lesson to learn is to understand exactly what margin is required. It will typically range from 5% to 33%. Blue chip stocks typically require around 5% to 10%, while the more volatile and arguably riskier stocks are typically 10% to 25%.
CMC uses this as an example to calculate your margin: ‘You wish to buy 3,000 shares at 110p the share has a 5% margin requirement, so 3000 x 110p = £3,300 (this is your total market exposure). £3,300 x 5% = £165, meaning that to open this position you will be required to deposit £165 as initial margin.’
The advantages of being able to trade on margin, or gear your investments, is that you can either trade the same size positions as you would do with your broker but free up your cash to use elsewhere. Or you can use the facility to increase your average deal size in the hunt for higher returns on smaller price movements. The latter, naturally, is a higher-risk option.
Therefore it is possible to purchase £10,000 worth of CFD shares to be asked for £700 margin. However, there may be a minimum opening balance required by your broker.
But remember that learning from other people’s mistakes means you should keep that cash in reserve to cover yourself, or at least cover yourself with a hedge trade. In fact, many investors have benefited from using their CFD account as a hedging tool to minimise the losses of their share portfolio and by benefiting from the fact that CFDs can still make you a profit in a declining market.
A sensible trading strategy is to profit from the mistakes of others and not to get caught in the same traps. Set your guaranteed stop losses and cover yourself at all times. Don’t be the one looking back and wishing for the power of hindsight, when in reality, we can all have that power by doing a little research to protect ourselves.