Ten rules to avoid getting blown up by CFDs

Smart Investor, February 2012

Contracts for difference (CFDs) give you the greatest opportunity for leverage of any investment product open to ordinary people. That is, for a certain amount of money, you can get 10, 20, even 50 times the exposure. Well, that’s great if you know what you’re doing, but it also means you can lose 10, 20, even 50 times as much as you would have done in an ordinary investment if you get it wrong.

“It’s like a sports car,” says Peter Esho, chief market analyst at City Index. “It can be a really great vehicle, but if you misuse it, it can be really detrimental to yourself.”

But there’s no need for that to happen. Used properly, CFDs can give an investor access to a range of interesting asset classes without running the risk of losing the house. They can even be used as a way of lessening risk rather than increasing it. In this feature, the experts explain 10 things to know about safe use of CFDs.

1. Just because you have leverage available doesn’t mean you have to use it

CFDs have always allowed clients a huge amount of leverage, and the margin they require is in many cases getting lower all the time. That doesn’t mean you have to use all of the leverage at your disposal. “Margin is like a speeding limit,” says Esho at City Index. “Just because the limit is 50mph doesn’t mean you always have to be driving at the limit. At different times you can drive at different speeds, taking into consideration safety. And just because you can have 5% margin doesn’t mean you have to leverage the complete 95%.” Never leverage beyond losses you can accept.

Having said that, leverage isn’t evil; it’s more a question of using it properly. “It’s all about understanding and harnessing the power of leverage and making it work to your advantage, but mitigating the risk,” says Chris Weston at IG Markets. “The whole principle is risk and reward. It’s not about being a hero and putting all your money on one trade: ‘I think BP is going to have a stellar night’ and lumping the whole lot on. That’s the first rule of how to blow yourself up.”

2. Use stop losses

The single most effective risk management tool available to CFD traders is the stop loss: something that will get you out of a trade if it declines to a certain point. All providers advocating using these widely as a basic matter of common sense. “When people go out and buy a house, they get insurance,” says Esho. “When they go out and buy a car, they get insurance. But they’re not used to using it around financial trading instruments. Stop losses are great insurance, particularly in markets that trade after hours or live so you can’t monitor them all the time.”

There is a temptation to have a mental stop loss in mind – an agreement with yourself that you’ll bail out at a certain level. Why then spend the money on a formal trading instrument to do so? “The very best kind of stop loss is an automated order you have in place,” says Steven Dooley, head of research at ForexCT. “It’s not good enough to say ‘I’m going to sell out when I’m down $200’. Once you’re in the trade, I’d say your decision making skills fall by about 90%.Watching the money tick over makes clear thought that much more difficult.” Far better, then, to set your original plans in stone with a stop loss order.

3. But not too close…

Readers who saw our diary of a CFD trader last year will recall a trap our trader (me) twice fell into: being right about the direction of a trade, but setting the stop loss so close that it was triggered in everyday volatility. This is not unusual.

“With a lot of our newer clients, a problem is having your stops too close,” says Dooley. “Every mistake you make in the market is a case of greed or fear. You can put your stop extremely close and think: if it goes the right way, I’ll be rich overnight. But that’s flawed thinking. Trading is about consistently making gains over the medium to long term.”

What does Dooley mean by that? Well, the bigger the exposure you take, the bigger the potential gain, but also the bigger the potential loss. So with a big exposure, assuming you have a set figure in mind that you can live with as a loss, then your stop loss will be much closer to the current trading level than with a smaller exposure. “That means they can only afford to give away a few points,” says Esho, and are therefore more likely to be knocked out.

One option many investors may not have considered is to have more than one stop loss on the same trade. “You don’t have to have just one point at which you put that stop loss: you can have several,” says Esho. “If the market moves against you, the first one goes, then the next, and the next, and the last. One flipside with a single stop loss is you might get taken out and then the market moves back in your favour but you’re out. The way to minimise that is to have different points so that if you’re knocked out, it’s only by the quantity of the first one.” The same principle applies in the other direction too: one can average in to a trade at various levels.

4. Understand guaranteed stop losses

There are two kinds of stop losses: the ordinary sort, and guaranteed. Guaranteed stop losses are designed to avoid a phenomenon called gapping, when there is a big difference between the closing price and the next opening price of a security, usually because of something that has happened out of trading hours. Let’s say, for example, Macquarie closes at a certain price, and then overnight something happens to world banking regulation that is bad news for Macquarie. By the time it opens the next day, it will do so at a much lower price – so there’s a gap. Those with a non-guaranteed stop loss can find that the gap goes straight over them so they don’t get out at their intended stop-loss price.

Some think this can be avoided with careful stop loss placement. “It’s good to have a look at the chart and make sure you’re not putting the stop loss in at levels where others are putting them,” says Dooley. “There are important support levels and, where they occur, the market will move rapidly because a lot of people have stop losses at the same place. That can result in slippage, where instead of losing $500 you lose $700 or $800.” For this reason, Dooley tends to avoid trading in names like BHP or Rio overnight because of the big gaps that can happen outside of their trading hours – macro news in the US or a key commodity, for example.

But with a guaranteed stop loss there’s no need to worry about that, though they do cost more. “It gives you peace of mind if the market gaps,” says Esho. “Regardless of what happens, you will be taken out at that point [the price you specified].” He has no problem with the extra cost. “If you go and buy a $30,000 car, you would pay insurance, and if you have an accident would pay your excess – you might spend two thousand dollars,” he says. “If you’re taking a $30,000 trading position, nobody is saying you have to pay $2,000 for a stop loss. But a lot of people still don’t put it on. People tend to overpay for some kinds of insurance but dismiss others where the vulnerabilities are a lot more.”

Weston points out that even if the company you have a contract on suddenly goes into liquidation, you would still get out at the point you expected with a guaranteed stop loss. “There were many cases in 2011 where stocks had massive slippage because of an announcement,” he says. “A guaranteed stop loss is a brilliant way to reduce any kind of risk.”

5. Don’t try to understand every asset class

CFDs give you access to a host of asset classes you may well never have traded before: oil, metals, soft commodities, foreign indices, forex trades. The effect can be a little like a kid in a sweet shop. “There are so many options in the markets that you don’t have to be across every single one,” says Esho. “We say: pick the markets and instruments you’re most comfortable with, that fit in with your overall strategy, and don’t try and jump across every single thing that’s available.” Spreading yourself too thin gets yourself into markets you can’t hope to fully understand. “A lot of the time when clients aren’t successful in trade, it’s because they chop and change and don’t have a clear strategy.”

Access to a range of asset classes is “one of the beauties of CFDs, but a double-edged sword,” says Dooley. His background is in FX trading, but there are currency pairs he is not interested in – yen-Swiss franc, for example – because he’s not used to them or the nuances that move them.

Generally, clients to tend to stick to what they know. Weston says IG Markets’ most traded products are the Australian dollar/US dollar pair, the euro, and the ASX 200 product. “It’s stuff that people have a relationship with every day. It’s easy to find news sources and research,” he says. But even with familiar themes and subjects, you do need to make an effort to work out what makes them tick. “So, for example, if you trade the ASX 200, you’ve got to understand the market composition, with the resources and financial sectors having such a massive weighting in our market, and with BHP and Rio such a large proportion. If those are not firing, the ASX 200 is not going to move.”

6. Don’t risk too much

Weston says money management is one of the keys to CFD trading. “I don’t want to allocate all my funds on one trade, because when you’re trading the market there’s a possibility you’re going to get your trade wrong. We use the mantra: we like to live to fight another day.” Like many others, he speaks of putting 2% of total capital on any given trade as a good rule of thumb. “That way you stand a chance of making money over a longer period of time rather than trying to make a killing in the first week or so of using CFDs. Look at a long road.”

Then, be consistent. “Make sure the stop loss amount is always the same amount of overall trading capital every single time,” says Dooley. “This is a trap people fall into. They see what they think might be a sure thing, or something that’s definitely going to happen, and they might risk a little bit more on that trade.” He, too, speaks of the common approach of risking 2% of the portfolio on a single trade. “If I suddenly decide to double the size of the trade to 4% a couple of times and they don’t go my way, that might wipe out a month of profit straight up,” Dooley says. “Inevitably, when you break your own rules, they never work out in your favour.”

Worse, losing money like this can prompt you to make the same mistake again, only worse. “If you double the size of risk it goes against you, it has a negative effect on your mental position. Trading, like anything, is a mental game; there’s a risk that people might try and make it back with an even bigger position,” Dooley says.

7. Manage risk first.

The point above – not risking too much on a single trade – is part of a broader point about the important of risk management. “The best traders are the best risk managers,” says Steven Dooley. “That is the absolute core of trading.” Successful use of CFDs requires investors to be utterly diligent about what they risk. “One reason so many people do badly is that the most important component of trading is also the most boring part: making sure that you are risking the appropriate part of your capital on each trade, and that in every single trade you have locked in a stop loss.”

Weston agrees. “Where’s my entry point? Where do I want to take profits? Where do I put a stop loss on the trade?” He stresses the importance of having a very clear plan before any trade.

8. Accept the bad days.

There are no perfect traders out there and you’re not about to become one either. There will be bad times, and they must be lived through with discipline. “A good trader would say they get it right 50 to 70% of the time,” says Dooley. “Unfortunately, you never get one right, one wrong, one right, one wrong – that’s not the way it works. You get five wrong in a row sometimes.” This happens to everyone and it’s important not to change trading patterns. “Sometimes there are volatile periods when you can’t make a buck to save yourself.” Or consider the corollary: “It’s that old saying: don’t confuse a bull market with brains.”

Equally, success can be oddly disorientating. “The feeling of making money can scare off a lot of people,” says Weston. “They feel like they have to close their position. “The best traders will hold for longer.” One option here is to trail your stop loss up – that is, once a trade is making money, move your stop loss higher up so that it locks in the gains you have already made.  “Traders, when new, do panic when they are making money. They let losses run instead of profits.”

9. Use them to hedge.

CFDs can be used not to make money, but to lower potential losses in other investments. “If you’re a farmer and want to hedge your crop for the year, you can come and use these tools,” says Esho. That might be through taking a position on a commodity, or a currency, or a combination: a currency position against a commodity. “There are different strokes for different folks.”

This can apply to ordinary equities: if someone has a holding in a particular stock, thinks it’s going to fall, but doesn’t want to sell out either because of capital gains implications or because they like the dividends and franking credits, they can short the stock. That way, even if the shares do fall, they won’t lose money. “It’s a way to smooth out risk in an underlying equities portfolio.”

10. Practice!

“We advise all clients to open a demo account,” says Weston, “to understand price action, what causes movement, and to understand one product before moving into a different area.”

Be aware, though, that there’s a big difference between trading on a demo and the real thing. “Trading on emotion with your hard earned money is very different,” says Weston. “Start small, and as you feel more comfortable, look to increase the stake.”

Before you open an account, any worthwhile broker will already have made sure you know what you’re doing. “If you’re new to trading, at IG we make sure there is a barrier to entry,” says Weston. “We make sure people understand what leverage is, sign a disclosure form, have a certain amount of money, and have traded shares for at least one year.” A good CFD provider will link you with an account manager and provide some sort of education programme as well. If they don’t, look elsewhere.