How to trade CFDs without losing your shirt

Trading is a great occupation if you don’t lose money doing it. Once losses are made – and start to pile up – trading can begin to lose its appeal very quickly.

Amateur traders who try their hand on Contracts for Difference (CFDs) can find that a small loss can escalate into a more serious loss – and fast. So if you don’t know how to plug the outflow of funds, then you need to learn some important lessons quickly.

Unless you’ve been hiding under a rock over the past few years, then you should have at least heard about CFDs. According to the Australian Stock Exchange, CFDs have been the fastest growing product over the past decade.

For those still a little unsure of the ins and outs of CFDs, then consider them like trading shares using a margin loan. Both products, CFDs and margin lending, let you trade shares using borrowed money.

Where the two products differ is that CFDs are a derivative – or merely a punt on the price performance of the underlying security, say a share – whereas a margin loan is used to buy physical stock. When you buy a CFD over Rio Tinto shares for example, you don’t own the physical shares, and you won’t be invited to the Annual General Meeting (AGM). You simply profit from any price movement up, and lose money from a price movement down (this is provided that you go long the stock).

Trading with leverage, or margin, introduces a rather unwanted friend to the trading table, commonly referred to as a margin call. The problem with highly leveraged CFDs – in contrast to using a margin loan to buy shares – is that margin calls typically land on your desk more frequently. That’s because CFDs are usually more highly geared than the traditional margin loan.

Small moves in the price of a CFD can mercilessly fling a trader into margin call territory.

For those unfamiliar with how a margin call works, a simple example is timely. Let’s assume that you have $10,000 in your account and you decide to leverage the full amount ten times to buy $100,000 CFDs priced at $1.00. For simplicity we are excluding brokerage and interest costs on the CFD trade.

If the CFD falls to $0.99 your exposure correspondingly falls by $1,000 to $99,000. To maintain a 10 per cent margin at least $9,900 is required in your account. So having lost $1,000, your account balance of $9,000 is short of funds.

A pop-up will appear on your trading screen with an alert indicating that a margin call is due. Most CFD provides will give you 24 hours, or two days on request, to close the position, add $900 to the account, or reduce your exposure to the stock.

If the stock continued to fall to $0.95 and you didn’t respond to the margin call, most CFD providers will automatically close the position out – wiping $5,000 from your account and leaving you with $5,000 remaining.

As you can see from this example, it only takes a small move in the price of a CFD for you to be hit with a margin call or be closed out of your position altogether. Because of the lower leverage used, traders who use margin lending to trade shares will have more room to move. For instance, a $10,000 deposit could be combined with a $23,000 margin loan to buy $33,000 worth of shares priced at $1.00 (using a maximum loan to value ratio of 70 per cent).

In this example, a margin call would not occur on a trader’s account until the shares hit $0.93, rather than $0.99 cents in our CFD trading example (most margin lenders allow a 5 per cent buffer before a margin call kicks in). Of course, the lesson here is that the higher the leverage employed the more likely it is that you’ll face a margin call on a trade.

The key lesson here is that the lower the leverage you employ, the less chance you’ll enter margin-call territory. Most experts say that you should never employ more than 10:1 leverage ($10,000 is leveraged to $100,000), even though CFD providers can offer as much as 20:1 ($10,000 can be leveraged to $200,000).

Another way to sidestep outflows from your account is to restrict the amount you risk on any one trade. Many commentators often say that a trader should never commit more than 3 to 10 per cent of your account on a single trade – which is clearly more viable for someone with $50,000 in an account than just $5,000. It thereby supports that argument that you need at least $10,000 in cash to legitimately start trading CFDs.

Another important step in minimising losses on CFDs is to always employ a stop loss and most importantly, know where to place it on a given trade.

Stop losses are pretty easy to explain for those unsure of the mechanics. Put simply, a stop loss is a pre-determined sell order that triggers a sell order at a particular price. Let’s say that you buy share CFDs on Rio Tinto at $120. On inputting the trade, you might decide to place in a stop loss at $118, which will automatically toss you out of the trade should Rio Tinto’s shares trade at $118.

Most professional CFD traders will not enter a trade without having a stop loss in place to halt escalating losses. The difficult part is deciding where the stop loss should be set.

Tight stop losses, which are placed at 1 or 2 per cent away from the entry price, will limit losses but will subsequently increase the chance of price volatility nudging you out of a trade. Wider stop losses, at say 10 to 20 per cent away from the entry price, will mean a bigger hit to your portfolio if you are stopped out, but will also spare you from being shoved out of a trade due to meaningless (only in hindsight) market wobbles.

As a rule, novice traders should use tighter stop losses, minimise leverage on trades to at most 10:1 and never risk more than 10 per cent of their account on a single trade.