With CFD trading you can make a lot of money very quickly. But the trade in contracts for difference is also very risky. If you do not know what you are doing, you can suffer large losses in a short time. That is why it is important to familiarize yourself with the risks of CFD trading. In this article we explain what the risks of CFD investments are, where these risks come from, and how you can manage CFD risk.
The risks of CFD trading
If you trade in CFDs, you generally apply leverage. This will be beneficial if the price moves in the right direction. A small price change magnifies your profit. However, if the price moves the other way, it will also be higher. And that means you can suffer considerable losses.
The key to successful CFD trading is to take maximum advantage of favourable price developments, while managing your risks at the same time. Below you will find a number of tips to limit CFD risk.
Managing CFD risk
A first advice that we really should give to everyone is: never trade with money you cannot afford to lose. This applies not only to CFD trading, but to all forms of investing in general (except for the most conservative investments such as time deposits or government bonds). Investing always brings with it certain risks and if you cannot afford to lose your invested capital, this risk is simply unacceptable. Moreover, most people are unable to make rational decisions about their investments if the money at stake is too important for them. And for CFD trading you have to be able to keep your head cool.
Invest only a small part of your investment capital in one CFD. For example, if you have deposited 1,000 euros with your broker to trade in CFDs, you should not invest everything in one asset. Instead, you should allocate 50 – 100 euros per CFD. To do so, you must choose a CFD broker that allows you to trade small positions. Because you do not pay transaction costs for CFD trading, it does not matter whether you trade small or large positions. By always trading small positions you only risk losing the value of one CFD, but this is compensated by other profitable contracts for difference. That way you protect your investment capital. As your capital grows, you gradually work towards a position size of 2-3% of your capital per trade.
Make good use of the ‘stop-loss’ function. Almost all renowned CFD brokers offer a stop-loss order function. A stop loss order specifies a certain price at which you want the CFD contract to be closed automatically. This means you take your loss, but you protect yourself against larger losses, which is key in CFD risk management. For example, if you buy a CFD on the DAX at a price of 12,000, you can set a stop loss at 11,500. If the DAX drops to 11,200, you lose 500, but your contract is terminated at 11,500 and you will not suffer additional losses of 300. In the beginning, you should start with stop-losses that are reasonably close to your purchase price, so that your risk remains small. If you find yourself being stopped out of a position too soon, you can start experimenting with a slightly wider stop-loss.
Diversify to reduce your risks. It is not smart to buy too many CFDs on the same stock, the same industry or the same market. For example, if you buy CFDs on the shares of Shell, Exxon-Mobil and BP, you may have bought three different companies, but a fall in the price of oil has an immediate negative effect on all of your CFDs. A short position on the oil price, on the other hand, could be a good way to hedge yourself if you also have Shell CFDs. This is called ‘hedging’. Similarly, you can use CFDs as a hedge for your other investments in, for example, stocks, bonds and currencies.
Start CFD trading
If you apply these techniques, the chance that you will lose a substantial part of your investment capital will be very small. Every individual CFD remains risky – leverage allows you to lose the entire margin on that specific CFD – but your total CFD investment risk is limited. This way you can make maximum use of the opportunities that CFD trading offers while protecting your assets.
For more information about CFD trading, read our CFD trading course