Q:Why is it important to distinguish between margin and leverage?A: A challenge for many novice traders in CFDs is deciding how much money to commit to each trade. Some CFD brokers like to tout their competitive margin requirements for stocks to get you to sign up but you shouldn’t factor this too heavily as leverage can quickly kill you if you overgear your account.
To illustrate the margin and leverage points we will open two positions with a $5000 account size -:
|Dummy Trade 1|
|Buy||2000 ABC share CFDs|
|Share CFD Position size/exposure||$10,000|
|Portfolio leverage||2x (as your 10k exposure is double the size of your capital; 5k)|
|Your $5000 trading account would then look something like this|
|Margin used in trades||($1,000)>|
|Free equity available||$4,000|
To see what happens when you open multiple positions with different margins we will open a second trading position -:
|Dummy Trade 2 (assuming you take a second trading position)|
|Buy||1000 XYZ share CFDs|
|Share CFD Position size/exposure||$10,000|
|Portfolio leverage||4x (as your 20k aggregate exposure is 4 X the size of your capital; 5k)|
|Your $5000 trading account would then look something like this|
|Margin used cumulatively in the two trades||($1,000) + ($500)|
|Free equity available||$3,500|
An inexperienced trader might still be thinking that he has $3,500 available margin for taking on additional positions, however with 4x portfolio leverage, every 1% move the market moves against you, you will lose 4% of your capital so a move of 10% against your total portfolio would wipe out 40% of your account. This is why it is absolutely crucial that you trade with stop loss orders and have a constant position size amount which you are willing to risk.
Q:How do I calculate my position size?A: Understanding leverage as a concept and in the context of the exposure multiplier relative to your trading capital is useful but it doesn’t help us determining what position size we should open to meet our risk management criteria. Every CFD trader should have a money management plan linked to his/her capital outlay, essentially this is a system that will make your capital last and enable you to survive losing streaks. Money management is a vital discipline for all traders who wish to give themselves the best chance of success in CFD trading.
The key to managing risk is to manage the position size of your trades. Position sizing is one of the most important aspects of managing your risk as it helps you identify the amount of your account balance you are prepared to risk with each CFD trade. New traders tend to focus on the outcome of the trade, overlooking the anatomy of risk factors and the tools to manage this risk. In reality the outcome of a trade is uncertain. The question then becomes: how much can I afford to lose on this trade?
Once you answer this question you will either want to adjust your position size or your stop loss. It is more important to adjust your position size than your stop loss, as the stop loss should be based on technical levels.
Formula for calculating position size -:
risk amount – commission / difference between entry and stop loss level = trade size.
$400 -10 / 20 cents = 1950 CFDs
1950 CFDs x entry price = Position Size
Let’s take another example this time only risking 1% of the pot. If you have an account valued at £10,000 and you want to buy a stock at £12 with a stop loss at £11.90, then the number of shares (position) to trade is:
Position Size = Maximum Risk Amount / Risk Per CFD
Position Size = (1% x account value) / (entry price – stop loss)
Position (no. of shares) = (1% x £10,000) / (£12 – £11.90)
£100 / £0.1
Number of shares to buy = 1000 shares
The method outlined above is typical of a method referred to as Fixed Fractional position sizing in which a certain percentage of the overall account balance is risked on each trade. The advantage of this trading method is that the amount you risk per trade is automatically adjusted as your trading capital fluctuates.
How much should you risk per trade? A common approach is to risk only 2% of your total capital per trade. Some say that this is too much and others say that it’s too little, however 2% is a good starting point for risk management if you are having 50% success with your trades. This will allow you to have a run of losses and still have a viable float to continue trading and at the same time, when profits go up 2%, 5%, 10% or more and you have leverage working for you, your profits can soon add up. Of course you could risk a larger percentage but keep in mind that the larger the risk % level, the fewer losses you can sustain before it becomes very difficult to recover.
Some stock market traders may argue you should risk more on the trades you are very confident in and less on the ones that you less confident. However, this might be unwise as we have already stressed that there is no certainty to any market related outcome and secondly it would be worth asking yourself why you would risk capital on positions that you didn’t feel confident about in the first place?
Total account size: $10,000
Risk 2% of total account : $200
A variation on the Fixed Fractional method is the Volatility based method of position sizing. This technique also uses risk as a certain percentage of the overall account balance on each trade, but the level of risk per security (share/CFD) is based on a measure of volatility, such as the Average True Range (ATR). Using this methodology, a CFD trader will take larger positions when volatility is low and smaller positions when volatility is high.
For instance, a CFD trader with a $20,000 account balance may decide to risk only 2% of his account on any one trade ($200). If the entry price is $1.25 and the ATR is $0.15, the stop loss might be placed at 2 X ATR, or $0.30. The quantify of CFDs to trade would then be $200 divided by $0.30, or 667 share CFDs.
Other possible ways to calculate the position size would be to buy or sell a fixed number of CFDs per trade or allowing a fixed dollar quantity to each trade or varying the trade sizes depending on your performance. The ‘fixed dollar risk model’ is good at managing risk but as opposed to the fixed percentage model the amount that you choose to risk per trade will not change in line with changes to your capital. In this model you simply determine an amount that you are willing to put at risk on each trade. Assuming this amount is equivalent to the amount in the example above i.e. $200. This amount is then divided by the share price risk. This method is used by some traders as it allows them to simply calculate a dollar figure that they are comfortable risking on each trade.
Q:To what extent do price moves impact your overall profit or loss?A: Because of the considerable leverage that is linked with CFD trading, seemingly small deposits can result in large moves in the overall profit or loss of your CFD brokerage account. Let’s take the case of a CFD priced at $3.20 that trades on a 10% margin. If a trader wants to buy 5,000 of these CFDs [$3.20 x 5,000 = $16,000 total market value], the deposit requirement would be $1,600. With this relatively small deposit, the trader will be controlling a position worth $16,000. On a position of this size, a price move of one cent will have an impact of $50 on the overall account balance.
A simple way to calculate the impact of price movements is to multiply the number of shares by the smallest movement in price. This is calculated using the following formula:
CFD position size X Minimum Price Movement = Dollars per point
|Calculating Impact of Price Movements on your Profit and Loss|
|CFDs position size||Price Movement||Dollars per point|
If you went long in the above mentioned CFD share at $3.20 and the price increased by $0.23, you would have made an unrealised gain of $1,150. However, if the price of the CFD fell by the same amount, you would have an unrealised loss of $1,150. Although these moves represent a 72% gain or loss in respect to the initial margin deposit, the overall impact will depend on the size of your total CFD account.
For a trader who has only $1,600 deposited with the broker, a trade that results in gains or losses of $50 per $0.01 of price movement will clearly have a serious impact on the overall Profit and Loss. However, if the same trade were taken by a trader with $50,000 in his account, the relative impact would be much less pronounced.
In other words a loss of $1,150 on a $1,600 would result in 72% of the total account wiped out in one trade. Conversely, a loss of $1,150 on a $50,000 CFD account would ‘only’ represent a 2.3% overall loss, which is obviously much less crippling.
To conclude CFD traders should take note of both the impact of a one-point ($0.01) move in the share they are trading and how this impacts their overall account balance.
Q:To what extent should I gear myself?A: We know that CFDs are a leveraged product but to what extent should you gear yourself? This in practice is up to you and your strategy but it should depend on your win vs loss and your risk vs reward ratios. To avoid taking on too much risk through the misuse of leverage, it is important to develop a strategy for calculating the appropriate size of your trading positions.
A reasonable position leverage could be a ratio of 1:3, which would allow an account with a capital base of $10,000 to have the buying power of $30,000. Once you establish a successful trading strategy and it is working along well, you may wish to increase your total account leverage further, perhaps to 1:5, where $10,000 can buy a $50,000 position. In this case a 1% increase in the value of a $10,000 position will equal a 5% increase in that of our investment – such is the power of leverage.
For this reason it is important that you are always aware of your esposure. Assuming the stop is say 4% away from the entry price and your account is leveraged 5x, if you have 3 similar trades overall then you are risking 20% on each trade and 60% of your capital on these 3 trades alone. True it can go both ways and you can make extraordinary returns as well but it is more important to protect your money than to chase bigger profits if you are aiming for long term success. Trading is a numbers game and margin trading can be deadly if you get it wrong and you get caught overleveraged.
Let’s take BHP as an example -:
|BHP Trading Example|
|BHP current price||$33|
|Margin of BHP share CFD||3% (means leverage of 97%)|
|Risk strategy account exposure 2%||$200 (assuming a pot of $10,000)|
|Quantity of BHP share CFDs to buy||202|
The important factor here is to be fully aware of the leverage amount and your financial open trade exposure at any one time.