Financial market risk is defined as the “potential for investors (or traders) to lose their investments due to events and factors outside of their control.”
Moreover, investing in the financial markets utilising the Contract for Difference (CFD) trading instrument brings innate risks due to the structure and nature of a CFD. In a nutshell, CFD is a leveraged financial instrument that is used to profit from a linked asset’s volatile price movements. Thus, it is the price volatility that drives the CFD’s risk profile.
According to the Jones Mutual financial managers, the primary reasons for this are because as a trader, you trade on margin when trading CFDs. And, the higher the price volatility the greater the risk that the trade will turn against you mid-trade.
On the other hand, the higher the risk profile, the greater the chance of trading profitably. Therefore, the secret to successful trading is to manage trading risk by implementing risk-reducing strategies.
CFD Trading: Risk management
It is essential to remember that in CFD trading, no matter how much planning and research you do, it is not possible to accurately predict an asset’s price movements 100% of the time. You can conduct thorough due diligence on an asset’s price movements using the fundamental and technical analysis tools at your disposal.
However, there is still the risk of surprise global geopolitical and socio-economic events that will change the outcome of a trade. Luckily, there are actions you can take to protect your trades against unexpected negative price volatility.
Even though, as mentioned above, you cannot plan for all eventualities, the origin of all successful trades to make sure that you plan your trades properly before you open a trading position. In other words, you need to decide on a trading strategy before you place the trade. Secondly, once you have decided on a trading strategy, the next vital step is to be cognizant of is the need to stick to your trading strategy.
Additionally, financial market trading is not dissimilar to conducting a war. This sentiment is echoed by Sun Tzu, a Chinese Military General who is well known for his book “The Art of War.” In this book, Tzu notes that “the art of war teaches us to rely not on the likelihood of the enemy’s not coming, but on our own readiness to receive him; not on the chance of his not attacking, but rather on the fact that we have made our position unassailable.”
So too, if you do not plan your trade properly and stick to the strategy that you have chosen, you will expose your investment to the risk of turning from a profitable into a losing trade. You also run the risk of placing losing trades.
Successful Trading strategies
Therefore, by way of ensuring CFD risk management, here are a number of successful investment strategies that you can use to minimise your investment’s exposure to risk:
All trades should have a stop-loss point set when placing the trade. This is calculated by determining the maximum amount you are prepared to lose when placing a trade. This is usually calculated by one of two rules:
- 5/15 rule: Firstly, you need to calculate 15% of the total value of your investment. Secondly, you divide the result by 3. Therefore, you can place three trades each with a stop-loss value of 5% of the 15% that you calculated at the outset of this exercise.
- 2% rule: This rule does not determine the number of trades you can place at any given moment. It simply states that the maximum amount you can afford to lose per trade is 2% of your total investment.
Unless you watch the trade for its duration, it is important to set a take-profit value. This is the maximum amount that you wish to make on a trade. It’s difficult to calculate this value as it is important to let a trade run to maximise profitability. However, if you let it run too long, you run the risk of it turning into a losing trade.
Essentially, implementing a day trading strategy means that you must open and close all of your trades within a single trading day. The primary benefit of this trading strategy is that the trades are not exposed to unexpected geopolitical and socio-economic events that occur overnight.