CFD Trading – What Are The Common Errors

Posted by Finance Professional on July 29, 2011 under Commodity & Futures News | Be the First to Comment

Trading mistakes can be made by even some of the most skilled professionals. Most errors made by traders come about as a result of a insufficient homework, data or control. Whilst it is very important learn from your mistakes, it’s even better and much cheaper to learn through the errors of others.

Below are some of the more common mistakes made by CFD traders:

1. Excessive Leverage.
One of many most important benefits of CFD trading is the ability to gain exposure to a stock, index or currency contract with a relatively small capital outlay. Rather than having to pay for the total notional value of the CFD position Contract for difference traders can enter into positions with margins as little as 5% or even less. One must always note that although a less significant capital outlay is required to open the position the Contract for difference trader continues to be subjected to the price movement of the share CFD for the full notional value of the position. A Contract for difference trader trading a Contract for difference at 5% margin is leveraging their initial outlay by 20 times, meaning a $5,000 deposit could possibly be utilized to open a $200,000 CFD position.

Because only a portion of the face-value of the trade is outlaid when buying and selling CFDs a tiny price change might lead to considerable gains and also substantial losses. For instance when trading a CFD with a margin of 5%, a price rise of 1% in the underlying instrument may lead to gains of 20%, on the other hand, if the price fell by 1%, it may lead to a loss of 20% of the amount necessary to open the position.

You should keep in mind that leverage is a double-edged sword not only can it work for you but when not handled correctly it might also work against you, often beginner trades pay no attention to the fact that if unmanaged gearing can lead to sizeable losses.

2. Not understanding the impact of trade sizes on your account
Due to the leverage associated with CFD trading, relatively small outlays can lead to large moves in your whole account balance.

For example buying 10,000 CFDs priced at $2.40 with a margin of 5% necessitates an outlay of only $1,200. With an outlay of only $1,200 you’re able to hold a $24,000 CFD position. Should the value of this position move one cent it would have an impact of $100 on the profit or loss on the traders account.

If the purchase price of the this position increased by 12 cents a return of $1,200 would have been made. However, if the price of the position fell by an equivalent quantity a loss of $1,200 would have been made.

The overall impact of any price movement will depend upon the traders overall account balance. For a trader with an account balance of $1,500, the aforementioned trade would have had a big impact on the traders account profit and loss. Should a trader with an account balance of $40,000 take the exact same position the effect would be much less significant.

A loss of $1,200 on a $1,500 account would lead to 80% of the whole account balance being lost. However, a loss of $1,200 on a $40,000 account would result in a losing only 3% of the account balance.

3. Trading in too large parcels
You should work out the exposure of your trade size prior to placing the trade. It is not uncommon for newbie CFD traders to simply trade the maximum size available to them based on their account balance without considering the amount of market exposure connected to the position.

There are a selection of methods traders can adopt so as to work out position size. A simply strategy is to work out a suitable quantity of risk capital should the trade go against you and work out an acceptable position size base on this.

In case you wish to limit losses on any given trade to $200 you would work out your position size based on your stop-loss price. As an example, if the CFD was priced at $1.40 and you stop-loss was at $1.15 your risk amount would be $0.25, to calculate your position size you’d basically divide the loss you’d be ready to adopt by the risk amount. In this case this would be $200 / $0.25 = 800, as a result your position size should be 800 units.

The method outlined above is known as fixed fractional position sizing in which a certain proportion of the overall account balance is risked on each trade. Other strategies incorporate allocating a set dollar quantity to each trade, buying or selling a fixed number of CFDs in each trade or varying the size trades based on the profitability of your account.

Using a position sizing approach may help you prevent the mistake of placing all your eggs in a single basket.