Contracts for Difference (CFD) have gained in popularity as a new and less capital-intensive way to trade stocks, indices, currency pairs and commodities in today’s financial markets. This form of trading, an offshoot of spread betting, originated in the UK, where it is estimated that hundreds of thousands of citizens engage in these types of security trading every day of every year. In recent years, CFD trading has rapidly spread to other regions across the globe, as well.
The compelling benefit is that you do not have to buy the underlying asset at its full face value. By using leverage or margin offered by your broker, you can purchase a position in the market at a much smaller value, yet still reap the full benefit of its subsequent move in the market, as if you had followed the traditional investment route. There are other benefits, as well, including the ability to short the market without restrictions or shift suddenly to indices when the general market moves suddenly in a new direction. Pricing is typically included in the Bid/Ask spread, such that scalping strategies may not apply.
Although leverage can greatly increase your chances for profit, it can also magnify your losses. These high-risk trading vehicles require knowledge, training, and as much practice on a demo system as you need to acquaint you with the nuances of the genre. At the end of the day, trading in CFDs does not that differ that much from trading in other market mediums. You still need to have a disciplined approach and a detailed step-by-step plan for achieving your goals.
You can win with CFD trading, but you can lose and lose big time. If you do not pay close attention to the pitfalls in this arena, then the following ten situations could ruin your day. We, however, want you to be on the winning side of the equation, and, for that reason, we have also included a companion piece to this article that details ten ways to win with CFD trading. Hopefully, both articles will provide an initial preparatory framework that will guide your first steps into the CFD world of investing. Awareness is a key step towards prevention, and, in that vein, here are ten ways that could cripple your foray into this new and exciting medium.
1) A Failure to Plan is a Plan for Failure: Traditional forex brokers, due to competitive offers from other brokers, have had to jump into the CFD market to keep up with the competition. Make no mistake about it, however, CFD trading is high risk, and it is not the same as traditional forex trading. Yes, you are now able to use leverage with other investment instruments, but the playing field is different. Spreads are larger. Overnight charges exist. Price gaps are another factor during the day, as well as between closings and openings. Margin calls can be frequent. How do you maneuver to win in this new and popular environment? Knowledge and preparation are key, but you must approach the market in a disciplined manner, which means having a step-by-step trading plan to follow every step of the way, one that you have tested during hours of practice. If you do not have a plan, then you are gambling, pure and simple, and when you gamble, the House always wins! Fail to plan – Prepare to fail!
2) Lose Focus and Lose Your Bearings: The beauty of CFD brokers is that you may have hundreds of asset choices at your beck and call from every region of the world from a variety of sectors, including currency pairs, commodities, indices, stocks, and bonds. The problem is that it is easy to get distracted and to leap at an active item that appeals to you on the spur of the moment. Part of being a disciplined trader, one that creates an “edge” for his advantage, is that you focus on investment items that are completely familiar to you and that you have had good experiences with in the past. If you want to test the new waters, try them out on your demo system or invest small amounts until you feel comfortable moving forward. If you are lost, you will lose, for sure.
3) Margin Calls are a Real Possibility with CFDs: Newcomers to CFDs are surprised to find out that there is a greater risk for margin calls than with traditional trading. If you do not pay attention, you can easily lose your investment and more. Consider this example: Company ABC trades at $100 a share. To buy 100 shares would cost $10,000. You decide to buy 100 CFD contracts with 10% margin (or 10:1 leverage) for $1,000. The price moves to $112, and you decide to close your position with a gain of $1,200, i.e., $12 X 100 shares. For your investment of $1,000, you would have more than doubled your money. BUT, what if the stock had gone down $12? Your loss of $1,200 would exceed your invested capital by $200. You would have received a margin call, and your general account would be charged for $200. For simplicity, we ignored spreads and fees, but you get the picture.
4) Ignore Risk Management at Your Own Peril: Risk and money management rules are there for one good reason – to ensure that you can return and trade another day. If you do not calculate how much loss you are willing to sustain with a prospective position, how will you know when to close it, when there might be a margin call, or exactly how much of your account is at risk? You need these answers before you enter the market. If the market does move in your favor, how do you protect your profits? Maximizing profits and minimizing losses are good things, which means that you are going to have both winning and losing trades. If your ego objects to losing, then you are letting your emotions take charge of your trading account. Successful trading is not about how many gains or losses your have. It is about how much you have gained, less how much you have lost.
5) Greed is Good or is It: If you are a disciple of Gordon Gekko, then just remember that he was fictional character from the movies. Greed might be ever present in our financial markets, but it is an emotion, along with excitement, euphoria, panic or fear, that must be contained or it will level your most formidable trading strategy and cause your calculations to go haywire. The only time to consider adding to your position is when the market is trending strongly in your favor, with momentum to spare. It is wise to take advantage of that type of situation, but these kinds of conditions are infrequent at best. If you want to double down or follow some Martingale method, where you keep doubling your losing bet until you win, on a pure whim or intuition, be prepared to kiss your money goodbye.
6) I am Smarter than the Market, I Think: Preparation and logic lead to good trades, but it is so easy to get lost in the analysis and to believe that you know something that the market does not. Have you ever found yourself saying this, “Sooner or later, the market will turn, as I know it will, and then I will win, while others lose”? With CFD trading, Pride truly does go before a fall. Avoid the ego trap of trying to be smarter than everyone else. Discipline will win over smarts every time, and, if it does not, then luck may have had something to do with it.
7) Never Add to a Losing Trade: How many times have you dropped your stop loss, as the market proceeded lower, and then, to compound your mistake, you added to your position in the hope that a small reversal might bring you back to whole again? NOT! Now, how many times does this storyline have to repeat itself before you learn your lesson? The CFD trading battleground is littered with casualties that never seemed to get the wisdom of this simple bit of advice. The quicker you learn to say “No” to losing trades, the quicker you will be on the right path to successful long-term trading.
8) Avoid Trying to Pick Tops and Bottoms: If you canvas veteran traders in the CFD space, you will hear story after story of the time when each one tried to guess at a bottom or top. Our minds want to believe that this task is what makes a veteran wealthy and wise, but such is not the case. This fault in judgment is most possibly an offshoot of the “I am smarter than the market” syndrome, but it is far too easy to lose a fortune attempting this “fool’s” exercise. Mentors will stress that the only consistent way to win is to go for the “meat” of a strong trend. Patience is required, as it is for most every aspect of trading CFDs, or any other investment medium, for that matter.
9) Impatience and Adrenalin do not Mix: Why are you trading CFDs? Is it for the chance at a huge return on less invested capital, or is it because the anxiety connected with trading high-risk assets is exciting and makes you feel alive? Perhaps, it is for both reasons, but in each case, it is the same “rush” that gamblers get at the betting table. When the adrenalin starts to flow, you may feel driven by the “flight or fight” sensation in your veins, but this response is part of our survival programming over the ages. In such a state, we tend to react, rather than think logically. Impatience and reacting with emotion are the leading causes for most early casualties in every trading pursuit, especially with CFDs.
10) Live in Hope, Die in Despair: Successful trading is about using discipline to acquire good setups that tilt the odds in your favor. Yes, you will win and lose under this scenario, but the one thing successful trading is not about is hoping for a good outcome. If you sense that you are hoping for things to change, then this is the first sign that your emotions are creeping back into your mindset. You have most likely stayed with a losing position longer than you should have. Close it, and move on. There is always another opportunity just around the corner. Leave your ego and emotions at the door and get back to your step-by-step trading strategy. Logic wins over time in this CFD trading game. Greed, impatience, and emotional intervention are to be avoided at all costs, if you truly want to beat the market.