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Managing Risk Key to Trading Success

-Sargon Elias, general manager, CMC Markets

Thursday 18th October 2007

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CFDs (Contracts for Difference) are one of the fastest growing financial tools on world markets and fast gaining popularity among many New Zealand traders who are enjoying their unique benefits. CFDs now account for an estimated 40% of turnover on the London Stock Exchange and are very much a mainstream retail product in London and also Australia.

A CFD mirrors the performance of a share or index and offers the benefits of trading shares without having to physically own them. Just like physical shares your profit or loss is determined by the difference between your buy price and your sell price; however because they are traded on margin you only need a small percentage of your trading capital to open up larger or more positions than you could open if purchasing the equivalent shares in the physical market.

This means that even though your outlay is small in comparison to the equivalent physical trade, you will still be exposed to the same potential profit and loss, thus your Return on Investment is magnified.

However this benefit is also what makes CFDs a high risk product. The good news for traders is that once you have opened a CFD position, there are a number of tools available to help you manage the position to make sure it is doing what you expect it to do; and if not – to ensure you get out of it quickly.

Some of the factors you need to consider include:

  • How much money are you allocating per trade considering the expected risk/return?
  • How much you are willing to lose on a trade?
  • Are you able to minimise losses if the market moves against you?
  • Does my CFD provider offer me other tools I can take advantage of if I am unable to monitor the markets myself?

When choosing a CFD provider, make sure they offer a comprehensive range of risk management and money management strategies at little or no additional cost.

CMC Markets provides clients with access to a variety of online order types which can be used to limit your losses and maximise your profits. These can be placed free of charge on any trade at any time during market hours and altered completely free of charge. Clients are also offered a free one day education course when they join, which covers risk management techniques as well as money management.

One of the most important tools to adopt for disciplined trading is the use of stop loss orders.

Using stops means you are automatically taken out of a position if the market moves against you, effectively limiting your loss. Stop losses can also be used to lock in profit. As the market moves in your favour you can move your stop order with the prevailing price, locking in profit if the market suddenly moves against you.

For example:
You believe the NZD may fall back a bit and be good news for one of New Zealand’s exporting companies, so you buy (go long) 1,000 Share CFDs at an opening price of $5.00. You believe the Share price will strengthen, but want to limit your losses in the event the NZD goes higher and place a stop loss order to sell 1,000 Share CFDs at $4.90, thus limiting your losses if the Share price falls to $4.90 or below.

Placing a stop loss takes the emotion out of the trade, as the emotional decision to sell out at a loss can be hard to take and people will often stay with the position believing that the trade will turn around, but in most cases the first exit will be the cheapest.

Not even the best investors in the world are right every time. Some clients may only get three out of every ten trades right, but on average, and because of the effect of the leveraging and the ability to set stop-loss limits, you can still make a profit on a 30 per cent hit rate by exiting those positions going against you quickly with a stop loss and continuing to hold the trades that are profitable.

This reinforces my earlier point that making money in the markets is not just about picking winning trades – it is about applying sound money management and risk management principles, and mastering these will be the key to longevity in the market.

*Sargon Elias is general manager of CMC Markets New Zealand, an online trading company that is the largest share, index, sector and margin FX CFD provider in New Zealand. CMC Markets is a global leader in financial trading with offices on four continents, providing clients in more than 100 countries with 24-hour online access to 18 international markets. CMC Markets launched the world’s first online, realtime Foreign Exchange trading platform in 1996 and in January 2000 it became the first company to offer online commission-free Contracts for Difference (CFDs). This started a revolution in trading around the world. www.cmcmarkets.co.nz

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