There will always be some people who point to the risks involved with trading contracts for difference, and decide that anyone who does so is just gambling. These people don’t understand the correct use of derivatives in general, and CFDs in particular.
CFD traders should not be allowed to open a CFD account on their credit card. Abusing leverage can be potentially riskier than going to the bookies because at least if you go to the bookies, if you put down $5,000 you only lose $5,000. Here, put down $5,000 and you’ve lost your house and your whole life savings.
In fact, as pointed out by ASIC recently, contracts for difference can be worse than gambling, as you can lose more than your stake. At least when you bet on the horses, or on a roulette wheel, you can only lose the money you put down. Whilst I think that comparing CFDs to a gamble is a little over the top this statement does ring true for many stock market traders who attempt to trade this instrument with little or no idea of what they are doing or how to manage their risk. The risk of wipe-out is very real too. Australia’s largest provider, IG Markets, for instance has filed 29 bankruptcy proceedings against clients since 2007 (average of about one bankruptcy application a month). But if you understand how this can happen, then you can avoid such a disastrous event.
The reason you can lose more than your account is that contracts for difference, in common with other derivatives such as futures, are a leveraged or geared financial product, allowing you to multiply the effectiveness of your money. You control, and benefit from, the change in price of a much greater value of stocks or other securities than you could own with the same money. This is great when you make a profit, but if you have a losing trade you need to make sure that you limit your loss. Traders typically ‘blow up’ because they ignore the risks. Using debt that magnifies initial investments by up to 100 times, a small move in underlying units can convert into big gains – or big losses – for an investor. Because you’re not putting up that much cash, say only 10% of the value of a trade, some clients tend to think they can make a lot of money easily.
But I do I have the control?
Keep in mind that as a CFD trader you are fully in control of the leverage you choose to utilise on your trading account and you aren’t obliged to use this leverage if you don’t want to. In fact you could treat your CFD account like a normal shares dealing account by only ever exposing yourself to the total sum of your capital. For instance, if you have $20,000 in your CFD trading account, you could for instance choose not take more than $20,000 in total positions which would imply that you aren’t using any leverage. In this scenario you would have no more risk than a conventional shares dealing account.
There are three things to look at to avoid the risk of ruin. Don’t just look at your trading plan and see how much profit you can expect to average – also check out how large the drawdowns can be, as there will be times when you have several losing trades and you need to survive those times. Don’t forget that if you are using for example a stock trading plan which has a maximum drawdown of, say, 20%, this drawdown will be multiplied by the CFD, so you will probably have to take a smaller position.
Another point to watch is if you hold positions overnight. If you trade in front of a screen all day, you can watch the slow progression of prices and decide if you need to exit the trade and cut your losses. If you’re in a daily market and hold positions overnight, you can be surprised by the security gapping open on the next day, giving you no chance to liquidate your position at the price you would have chosen. Depending on your style and timescale of trading, there are two things you can do about this. One would be to never hold a position overnight; the other is to limit your exposure by taking a reasonable view of the worst that can happen, and sizing your trade appropriately.
The general rule of thumb to protect any trader from being wiped out is that you only risk losing 2% of your account. Some people also say you should not put more than 10% of your account into any single trade. It takes a little mathematics to calculate, but if you know where you’re putting your stop loss, which you should do anytime you trade, then you can fairly easily work out how much you can afford to put in, and still survive a bad spell.