HOW TO MANAGE YOUR RISK IN CFD TRADING
To successfully trade the capital markets, you need to integrate a risk management strategy as part of your trading routine. Those who do not formulate a risk management plan for products such as CFDs or forex will find it difficult to maintain a profitable account.
Your first task should be to decide, based on your capital, the amount of money you want to lose and your target profit for a certain period of time (daily, weekly, monthly, etc.)
Following this decision and before entering your first position, you should formulate a risk management plan, determine your reward versus risk ratio, and understand the leverage you are using by your broker. In this article, we will cover the basic ‘rules of thumb’ for a successful trading strategy.
CONTRACT FOR DIFFERENCE
Contracts for difference (CFDs) are widely traded instruments that allow you to trade multiple products including equities stocks, indices, commodities, cryptocurrencies, and currencies. Many reputable brokers such as HQBroker offer CFDs with a wide variety
securities. When you buy or sell CFDs, you are responsible for the difference between your buy and sell prices without actually owning the instrument.
The amount of capital you need to post for CFDs will depend on the volatility of the instrument. One of the advantages of CFDs and the reason for their popularity is that you don’t have to post the entire value of the security but a portion of the total transaction value.
CFDs are geared towards investors who wish to speculate on the direction of a currency pair or security and provide an advantage over standard stocks or ETFs purchased through an exchange.
For example, if you are interested in trading Apple stock, the amount you need to post for a CFD is about 5% of the amount you would post if you bought stock at a stockbroker. A retail CFD broker will evaluate your most losses based on the CFD and provide you with a margin calculation.
The risk management you incorporate into your trading strategy should be based on your risk tolerance. Any strategy you develop should be based on a business plan that describes how much risk you plan to take and the benefits you expect.
It is important to understand that each trader has a different risk tolerance and therefore, each trader must establish an independent risk management. For that, it takes time to become a profitable trader because you have to be aware of the qualities and shortcomings of your trades.
RISK VERSUS REWARD AND PROFIT FACTOR
Successful traders are aware of the risks they will take on each trade and the rewards they will receive before making a trade. There are two ratios that can help in this process. The first is the reward versus risk ratio and the second is the profit factor.
The reward versus risk ratio is the reward divided by the risk. A successful trading strategy will earn more than it loses. For example, if you win $2 on each winning trade and lose $1 on each losing trade, your reward for risk is 2 to 1. That’s pretty simple.
For new traders, this ratio can be useful. You need to decide on a certain positive ratio and whatever happens during your trading time, you have to apply this ratio.
The second ratio is the profit factor ratio. To calculate this ratio, you divide your gross winning trades by your gross losing trades or, or, you multiply your average win rate on successful trades by your winning percentage and divide that number by the average value on unsuccessful trades times your losing percentage. You.
Profit factor = (trading gross win) / (trading gross loss) or = (rate of win x average win) / (rate of loss x average loss)
CATCH THE TREND
One of the more common steps after forming a trading strategy is to incorporate technical indicators into your trading tools. The moving average crossover strategy is geared towards capturing the medium term trend where you buy/sell a currency pair or CFD.
The reason why it’s important to learn the skills to catch trends is that to become a profitable trader and implement your risk management strategy, you need to know how to earn more than you lose, meaning catch the trend.
The indicator signals you to buy your asset when the short-term moving average (20-day moving average in this case) crosses above the longer-term moving average (50-day moving average in this case). You would trade the other way around when the 20-day moving average crosses below the 50-day moving average.
The risk management you use when trading a trend following strategy could be one where you lose 3% while looking for 10% gain. For example, you want to make $1,000 and you are willing to lose $300 on each trade.
If you trade 9 times, lose 6 times ($1,800) and win 3 times ($3,000), you will make a profit of $1,200. The key is to find a risk-reward profile that meets your trading goals. In this example, your reward versus risk level is 3.33 to 1, and your profit factor is $120.
If you use a different type of strategy, where your winning percentage is higher than your loss percentage, then the amount you lose can be the same as the amount you gain.
If you win 60% of the time and lose 40% of the time and you risk $100 on each trade, after 10-trades you will have a gross profit of $200.
Since you believe in moving average indicators, it is time to move forward and study other indicators such as Fibonacci, Bollinger bands, relative strength indices and integrate them into your charts.
CUTTING YOUR LOSSES AND LEAVING YOUR PROFITS
One important concept is to let your profits run while cutting your losses. This is very important for a trend following strategy. The risk management strategy you use should incorporate this concept by using a trailing stop loss. This is a dynamic stop loss technique that changes with the market.
You can use percent stop loss when designing trailing stops or absolute numbers. The goal is to hold your position until the market reverses direction.
For example, if you buy EUR/USD with the aim of making 2% while only risking 1%, once the market goes up 1%, you can move your stop loss up to make sure you don’t lose the 1% you have as unrealized profit.
When the market goes up, you keep moving your stop loss until the market reverses and hits your trailing stop loss. This will allow you to maximize your trading while catching the trend.
Note that not many brokers provide trailing stop losses. A good broker allows traders to trade with a trailing stop loss function.
HOW TO TRADE CFDS WITH PROPER RISK MANAGEMENT
Before trading with real capital, you should make paper trades to determine if your trading strategy can work. Another important risk management concept is to stick with your strategy.
Novice traders will often exit early positions especially if they lose money, not giving the strategy a chance to be unsuccessful. Also, it’s easy to marry into trading, allowing the market to move against you past your stop level, which can put you at risk of crashing.
Another important feature of CFDs is that you use leverage. Higher leverage equals greater risk. For your trading strategy to be successful, you must know the leverage your broker provides and in particular, the instruments you use.
DAILY TRADING RISK MANAGEMENT
Day trading is an activity where you plan to exit the position you took at the end of the day. The day trading strategy is focused on entering and exiting intra-day positions. Before trading any forex pair or CFD you should evaluate the historical daily range so you know how much you can expect or earn on any given day.
For example, the historical range, from daily high to daily low, of crude oil prices over the last 3 years is $0.50 per barrel. Therefore, if you are trading crude oil daily, you can evaluate the daily changes based on historical data. Obviously, volatility is higher for other instruments like cryptocurrencies.
The risk management you use should focus on exiting your position with a profit or loss at the end of the trading day, as well as, figuring out the risk to reward ratio that will fit the daily range of the product you are trading.
That is, when you trade during the day, you should have a daily limit to how much you can lose and while you want to squeeze a lemon on a profitable day, sometimes it’s not a bad idea to limit your profits.
Apart from that, you will also want to incorporate slippage and commissions into your trading activity. Slippage is the amount of capital you normally lose by entering or exiting a trade. The commission also includes the offer/bid spread your broker provides. If you are trading crude oil and the bid/bid spread is $0.02 per barrel and the slippage when you enter the trade is $0.01, then you need to subtract $0.03 from each trade when you design your trading strategy.
Risk management is an important concept and you should plan the amount of risk you are willing to take before starting any trade. Your risk management style should be based on your financial goals, your risk tolerance and your personality.
Remember, you get paid to take risks and the rewards you earn will be based on the risks you take. The more you risk the more rewards you expect and the less risk you take can make you a solid trader.
You want to design a trading strategy that has a positive reward versus risk ratio and make sure you cut your losses and let your profits run. That’s the main goal.