When it comes to trading Contracts for Differences (CFDs), risk management is an essential aspect of success. CFDs allow traders to speculate on price movements of financial assets without owning them, providing great flexibility and potential for profit. However, they also carry significant risks. Effective risk management strategies can help traders mitigate these risks and protect their capital.
In this article, we will look at some of the commonly encountered risks in CFD trading. We will also explore 6 effective risk management strategies that traders can employ to take better care of their portfolio and make the most of their CFD trades. If you are eager to learn more, read on.
The risks of CFD trading
There are several commonly encountered risks in CFD trading that traders should be aware of. They include leverage risk, market risk, counterparty risk, and liquidity risk. Let’s look at them in detail.
Leverage is a tool that is popular amongst traders as it can increase the position size that a trader can control in the market. When a trader trades with leverage, they can potentially amplify their profits. However, should the markets move against them, they may also find it difficult to recoup the amplified losses they incur. Leverage risk is one of the most common risks CFD traders face – especially novices.
Market risk is the uncertainty that the price of the underlying asset – tracked by the CFD – will move in an undesirable direction. This can be due to a range of factors, depending on the instrument. For example, economic data releases such as interest and inflation rates and GDP, geopolitical events such as international conflicts, and investor sentiment, can all affect the price of an instrument.
CFD traders buy or sell their contracts from a CFD provider, which is the counterparty in the transaction. When trading CFDs, the counterparty may default on their obligations, which is a risk that all CFD traders run. When that happens, the CFD loses their funds. However, this risk is negligible when a CFD trader works with a reputable provider or broker
Finally, CFD traders may face liquidity risk. This is the risk that there may not be enough buyers and sellers on the market, when there is a lower demand for a CFD contract than there is a supply of it. In times of low liquidity, it makes it harder for CFD buyers and sellers to buy or sell their contracts at their desired price.
6 effective risk management strategies to employ
Below are 6 effective risk management strategies that traders can employ. However, they should not be construed as advice taken at face value, and traders should evaluate their portfolios and the instruments they are trading to choose the most appropriate strategy to use.
Work with a reputable broker
The most important risk management strategy may not sound like one, but it is to work with a reputable broker that is licensed. In Singapore, this is any broker that is regulated by the Monetary Authority of Singapore (MAS), which is the country’s central bank and financial regulator. When you work with a reputable broker, you can ensure your funds are kept safe and that trade execution is fair and transparent. You can also discover more competitive prices (spreads) when you trade. A good example is Saxo CFD broker, a Danish investment bank that has a local and regulated presence in Singapore.
Use stop-loss and limit orders
A stop-loss order is a market order that is placed when a trader enters a position, and it is essentially an instruction that asks the broker to automatically close out the position when the asset reaches a certain price. This strategy can help limit potential losses when the market is unstable and there are large fluctuations.
A limit order is a similar kind of market order, and it is also placed with a broker when a trader enters a position. A limit order can ensure that traders enter or exit a position at their preferred price or better. This can reduce the risk of slippage – which is when there is a difference between the expected execution price and the actual one, due to high latency.
By using these market orders when opening positions, traders can minimise the risk of being stuck in the market at undesirable times. This can lead to a protection of the trader’s portfolio, and their losses can be limited to a certain point. Brokers also execute these orders automatically, so that traders do not have to monitor market movements 24/7.
Diversify your portfolio
Diversification is the act of spreading out one’s funds across various asset classes and instruments to spread out the risk of one market tanking. Diversification can help reduce potential losses in any area, and it can protect traders against market volatility and unforeseen events, preventing portfolios from being wiped out.
Hedge to offset losses
Hedging is a strategy that involves existing positions. It is the act of opening a new position – either by going in the opposite direction of the original existing position or taking a new position in another market on a related instrument. Hedgers do this to offset potential declines in the original position.
As mentioned, leverage is a tool that can potentially amplify profits – but it can also increase losses if the market goes against a trader’s position. Leveraged trading ultimately involves borrowing funds from the CFD provider or broker to increase the trader’s original size, and if the trade does not work out, the trader can lose a lot of money. Managing leverage means understanding your risk tolerance as a trader and having an awareness of your account size and not risking more than you can afford to lose. It is important for traders to remember that they can always increase the use of leverage, but once they start off using high leverage and experience a loss, it is hard to come back from that.
Use position sizing
Finally, position sizing is a great strategy for those who prefer to trade more conservatively. Position sizing is the process through which traders determine the appropriate size of a position they should take based on their account size and risk appetite. There is no set rule for how much a trader should trade – because everyone is different. However, a good rule of thumb has always been that traders should not trade more than 2% of their total account funds, and many traders find this helpful. This strategy ensures traders do not go in over their heads and risk too much of their account in one trade.
CFDs present potentially lucrative opportunities for traders that know what they are doing and have a strong understanding of the markets. It is worth saying that these 6 risk management strategies can be very effective in minimising potential losses and mitigating certain risks, but they are not foolproof. There will always be risk involved in the world of trading and investment, and profits are never a guarantee. Therefore, traders should enter markets with a sound mind and understand that you should never trade with more capital than you can afford to lose.