What Are The Risks?

Now I mentioned earlier, that there are risks involved with CFDs, and I’m sure you’ve already thought of the main one – the risk of losing money. Now let’s be clear – no matter how you invest or how you trade, there will always be the risk of losing money. Professional traders manage that risk by using stop loss orders to cut their losses quickly, before they have a chance to grow. And while stop loss orders are always important, they are doubly important when it comes to CFDs. Let’s explore that using the same $10,000 trading account example from above.

If you buy $10,000 worth of shares and the market goes up by 10%, you make $1,000. If it drops by 10%, you’ll lose $1,000. It’s not nice, but it can happen. If you have a $10,000 account and you buy $50,000 worth of shares or five times the previous amount, your profit or loss will also be multiplied by five times! So a 10% gain on a $50,000 position nets you a $5,000 profit, which is actually a 50% return on your $10,000 capital! How many trades like that would you need to make per month in order to replace your existing income? Food for thought!

However, a 10% loss on a $50,000 position will net you a $5,000 loss, which would mean you’ve lost half of your starting capital. In trading, we call that an unacceptable loss! So how do you manage this additional risk on CFDs? The key is to keep your losses small by cutting them as soon as you are wrong, and let your profits grow by letting them run, and not banking them too early.

How Can You Manage Your Risk?

Whenever I enter a trade, I have a fixed percentage of my account that I am prepared to risk and no more. So I build a position with that number in mind, and place a stop loss order at a technical position in the market (I use swing charts to determine these positions) that gets me out of the market as soon as the trade has gone wrong. This way, my losses are always small and I don’t put my account at risk. Then, I let the trade run with the aim of banking a larger profit, rather than a smaller profit. In general, I aim to make at least ten times what I am risking on a trade (called a 10 to 1 Reward to Risk Ratio), which means if I risk $1,000 on a trade, I want to make $10,000 if I’m right. If I risk $10,000 on a trade – well, I’ll let you do the maths on that one!

What Costs Are Involved?

Now, I mentioned earlier that there are no loan applications, no legal fees, stamp duty or repayments. But there are two costs to keep in mind, and also the subject of margin, so let’s look at those now. If you buy shares using your own money, you will pay a small brokerage charge for every transaction, whether you are buying or selling. CFDs are no different, although in many cases the brokerage is actually a little bit cheaper. However, because you are trading leveraged capital and effectively borrowing money to trade these larger positions sizes, there will be an interest charge on positions held overnight. Generally speaking this is very small, usually the central bank rate plus 2 or 3%. (You can actually get paid interest on short positions if the central bank interest rate is high enough, but that’s a discussion for another day!) So CFD trades will generally have brokerage costs and a small interest component as well.

There is a third component here which may seem like a charge (but isn’t) and that’s called margin. Margin is a security deposit that you must leave with your broker in order to trade these larger positions. Margin protects the broker but also protects us as traders because it stops us from trading positions that we cannot afford. Margin levels have come down in the last few years, but you can still trade currencies on as little as 3.33% margin (meaning $33,333 can control a $1,000,000 position!) and stocks on 20% margin, meaning $10,000 margin could buy up to $50,000 worth of stocks.

The way margin works is that the money actually stays in your trading account, but it will be ‘locked up’ so that you can’t use it for trading. So if you have a $10,000 account and buy $20,000 worth of shares on 20% margin, $4,000 of your account (20% x $20,000) will be locked up in margin. Your trading account will have $10,000 in it, but only $6,000 will be available for trading.

If the shares you are trading in move up or down in value, your trading account value will also move up and down. If the value of your total account drops below the required amount of margin (in the case above, $4,000) then you will receive a margin call, where your broker politely asks you to either close some of your position or put more money into the account. However, if you manage your risk and don’t over-trade, you won’t receive very many (if any!) margin calls.

In summary, CFDs are a leveraged product that act like a magnifying glass to your trading. They will magnify your profits, but they will also magnify your losses, which is why at Safety in the Market, we focus on safety first in our trading. If you don’t trade with safety, you can forget your dreams of being a professional trader who works from home in their own hours and lives off their trading, because it will only be a matter of when, not if, you lose all your money. So remember, trade with safety!

CFDs are discussed further in our Active Trader Program, and each month in our Active Trader Program Coaching classes.