Trading mistakes can be made by even some of the most experienced professionals. Most mistakes made by traders come about because of a lack of homework, data or discipline. Whilst it is very important learn from your errors, it’s even better and far less expensive to learn from the errors of other people.
Below are a few of the more common errors made by CFD traders:
1. Extreme Leverage.
One of the main benefits of CFD trading is the ability to gain exposure to a stock, index or foreign exchange contract with a relatively small capital outlay. Rather than paying for the total notional value of the Contract for difference position CFD traders can enter into positions with margins as low as 5% or even less. One must always note that even though a less significant capital outlay is required to open the position the CFD trader is still subjected to the price movement of the equity CFD for the total notional value of the position. A CFD trader trading a Contract for difference at 5% margin is leveraging their opening outlay by 20 times, meaning a $5,000 deposit could be used to open a $200,000 CFD position.
Because only a portion of the face-value of the trade is outlaid when buying and selling Contracts for difference a small price change can result in significant gains and also substantial losses. For example when trading a CFD with a margin of 5%, a price rise of 1% in the underlying instrument may result in gains of 20%, however, if the price fell by 1%, it may lead to a loss of 20% of the amount required to open the position.
It is important to keep in mind that gearing is a double-edged sword not only can it work for you but if not handled correctly it might also work against you, often newbie trades take no notice of the fact that if unmanaged leverage can result in considerable losses.
2. Not understanding the impact of trade sizes on your account
As a result of the gearing linked to CFD trading, relatively small outlays can lead to substantial moves within your overall account balance.
For instance buying 10,000 CFDs priced at $2.40 with a margin of 5% requires an outlay of only $1,200. With an outlay of only $1,200 you can actually 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 the same quantity a loss of $1,200 would have been made.
The impact of any price movement will depend on 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 same position the effect would be much less significant.
A loss of $1,200 on a $1,500 account would result in 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. Buying and selling in too large parcels
You must work out the exposure of your trade size ahead of placing the trade. It is common for newbie CFD traders to simply trade the maximum size available to them determined by their account balance without considering the amount of market exposure connected to the position.
There are a variety of techniques traders can adopt in order 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.
Should you wish to restrict losses on any given trade to $200 you would work out your position size based on your stop-loss price. For instance, if the CFD was priced at $1.40 and you stop-loss was at $1.15 your risk amount would be $0.25, to work out your position size you would simply divide the loss you would be prepared to take by the risk amount. In this instance this would be $200 / $0.25 = 800, consequently your position size should be 800 units.
The method outlined above is called fixed fractional position sizing in which a specific amount of the overall account balance is risked on each trade. Other methods 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 in accordance with the profitability of your account.
Using a position sizing approach will help you avoid the mistake of placing all of your eggs in a single basket.
