Contracts For Difference (CFDs) are among the most popular financial instruments traded online. Trillions of dollars are traded each day. However, CFD trading carries high risks. Any trader who has bought and sold these financial instruments will agree that even a small mistake can wipe out a huge chunk of your investment. On the other hand, a winning trade can earn you multiples of the invested amount in profit.
Besides the allure of making big money, traders opt to trade CFDs because they are settled in cash rather than securities or physical goods.
What is a Contract For Difference?
A CFD is essentially a contract between a buyer and a seller. The contract stipulates that the seller will pay the buyer the difference between the current value of an underlying financial instrument and its value at contract time (expiry of the contract). However, if the difference is negative, it’s the buyer who pays the difference.
The buyer is essentially speculating that the value of the underlying asset will either go up or down. The difference is settled in cash. Therefore, the buyer doesn’t actually own the financial instrument being traded but holds on to the CFD until the contract ends.
Some of the financial instruments traded through CFDs include precious metals, crude oil and equity derivatives.
There’s no doubt that there’s money to be made trading CFDs. Unfortunately, a huge percentage of traders often find themselves on the losing side (difference is negative). It’s usually due to avoidable mistakes five of which we explain below.
Top 5 CFD trading mistakes that you should avoid
1. Placing more than is necessary on a single trade
You’ve done your homework on a particular instrument and are confident on the price direction. To maximize on your profit, you decide to place 50% of your account balance on it. The price moves in your speculated direction. Then, it suddenly reverses. Luckily, you’d placed a stop loss but a huge chunk of your invested amount is now gone.
This is a scenario even experienced traders have gone through.
The CFDs market is highly volatile. Price movements suddenly reversing is quite common. So there’s no way to be 100% sure that a specific trade will end at a certain price point.
To avoid this mistake follow a simple rule. Never place more than 2% of the available account balance on a single trade. In addition, even though leverage is meant to increase a trade’s profit potential, you should use it sparingly.
2. Going in blind
Simply speculating price directions without understanding why it might go up or down will result in loss. The volatile nature of CFD markets is influenced by underlying factors which range from politics to weather. Always have enough information regarding the factors that affect the price of a financial instrument before investing your money on it.
Many brokers actually make it easy to get the necessary information. They will provide easily accessible charts, indicators and other technical analysis tools that you can use to gain more knowledge. If you want to invest in a particular instrument always take time to understand the factors that will affect its price to change fully even if it will take several hours. That knowledge will save you money.
3. Not knowing the risk in a trade
This is one of the most common and easily avoidable mistakes. Traders simply place a trade where the profit potential is lower than the loss that can be incurred. Several trades like this can easily wipe out your entire account.
Before placing any trade, consider the amount of profit you might gain versus the loss you might incur. If the loss is higher, it’s better to forgo the trade over increasing leverage or the invested amount.
Managing your risk also involves finding just a few instruments to trade. Most brokers will offer dozens of instruments for traders. This doesn’t mean that you must place your investment in every one of them. It’s more prudent to identify two to five different instruments to build your portfolio. This allows you to learn as much about the instruments as possible and eventually be in a position to make trades whose probabilities are in your favour.
4. Not planning or following through on your plan
Every successful trader enters a trade with a plan. Planning involves answering several questions such as:
– What financial instrument will you trade?
– Depending on the existing conditions do you go long, short or avoid investing on that instrument?
– What is the maximum and minimum amount you’ll invest?
– What strategy will you use on your trade?
– Will you reinvest your profits or hold on to them?
These are just a few of the questions you’ll need to answer before entering a trade. But before asking these questions you must at least have enough information about the instrument and the trading platform.
Not following through on your plan is another closely related mistake. For example, you might decide to hold a losing trade longer in anticipation that it will rebound. If it continues on a losing position, your loses will continue piling up. If your plan is not working, it’s best that you first stop trading and go back to the drawing board. Learning from experienced traders is another way to identify plans that actually work.
5. Failing to utilize stop orders
Stops are one of the most important risk management tools available to any CFD trader. They come in handy when you want to lock in profits or minimize losses on a trade. For every trade you make, it’s advisable to make use of stop orders. This allows you to minimize loss and lock in profits earned on a winning trade whose price direction suddenly reverses.
Another strategy for using stop orders is to space them out. Many traders often place their stop orders close to the starting price that they eventually won’t make any profit if the stop comes into play. This, however, doesn’t mean that you space your stops too far apart. If you’ve planned well, applied risk management techniques and selected a future whose probability of winning is high, you’ll be able to confidently place your stop orders at the right place.
Trading CFDs is a risky venture. Many would be traders quit investing in CFDs after watching their accounts get depleted simply due to avoidable mistakes. There are many other different mistakes that we’ve not mentioned. But if you’re able to avoid the five we’ve outlined above, you should be able to avoid huge losses wile slowly growing your trading account.
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