Trading CFDs without a proper risk management plan can expose you to unnecessary risk. As an example, if you allocate a sizable percentage of your trading resources to a trade with no proper risk management strategy, you place all of your trading capital at risk, meaning that in the event you sustain a loss you'll no longer be able to trade. Losing your entire capital base can force you out of the market and you will not even have the chance to make back your losses.
The most typical form of risk management is trade sizing, this is also referred to as the fixed dollar trade size model. In this example an identical amount of capital is used for each trade.
As an example, if you have $100,000 to invest, you'll need to figure out just how much to put into the trade. To work this out you would simply divide $100,000 by the cost of the CFD. If the previous traded price of the CFD was $8.50 you'd divide this by $100,000 to determine the amount of CFDs you can buy. In this case the number would be 11,764.
In order to work out the amount of risk involved in the trade you will have to work out just how much you can afford to lose if the CFD move against you and place your stop-loss at this point. This is also referred to as the stop-loss distance, that is the distance between the entry and stop-loss price.
For instance, if your stop-loss price is $8.00 and entry price was $8.50, this means that your stop-loss distance will be $0.50. If you have 10,000 CFDs your risk will be 10,000 multiplied by $0.50 or $5,000. In this case your risk would be $5000, which equates to the quantity that you could potentially lose should the position move against you and you get stopped out.
It is also imperative that you factor in the cost of commission and any financing costs that you could have incurred from holding the position overnight.
In the fixed dollar trade size model the quantity of CFDs that you buy and sell every time will not always be the same, it's because the stop-loss size will vary depending on the risk appetite that you have on the trade.
A different form of risk management is compounding, this means that as your trading account balance rises, you are able to open bigger positions.
For instance, if you have a starting balance of $100,000 and you have determined that you can afford to have 10 trades open at any given time, as your trading account balance grows, you will be able to take on larger trades. This plan can be used up to a point when your draw down gets too large for your liking and risk appetite.
It is also vital that you note that if you’re trading a CFD that has liquidity issues, you might get to a point where your trade sizes are too great, as such you will have to take smaller positions.
Author Resource:
Brian Hays is an expert CFD trader and writer having written numerous ebooks and articles on CFDs and how to manage the dangers associated with them. You can find Brian's ebooks and learning material relating to CFD trading on-line.
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