Risk management is the proces of identifying and assessing one’s risks when trading to control them, with the goal of minimising potential losses. In trading, traders often have risk management strategies and approaches depending on their trading preferences and instrument. In this article, we will go through the importance of using risk management strategies when trading CFDs, as well as some common risks that traders encounter and how to manage them.
CFD trading is a potentially lucrative endeavour, but traders should always keep in mind that there is no such thing as guaranteed profits in the financial markets. Knowing this, if you would like to start trading CFDs, you can visit Saxo Bank to open a live account. If you want to learn more first, read on.
The importance of risk management
Risk management is important for several reasons, including both the ability to minimise losses and to improve one’s skills and enhance returns. Below, we examine why traders must have a strategy in place before they begin trading.
To minimise losses
Many people apply risk management strategies to minimise losses by reducing the impact of adverse market conditions, or by eliminating unfavourable conditions altogether. One example is setting a stop loss order when entering markets, so that when the price of an instrument hits a certain level, traders can automatically cut their losses and move on. This minimises losses while simultaneously giving traders the freedom to take a more hands-off approach when trading.
To enhance returns
Another reason traders set risk management strategies is to enhance returns over time. By managing risk effectively and reducing scenarios in which traders will lose money, traders can take on more trades with higher potential returns without risking their entire trading capital. One example is using position sizing, which means adjusting the size of your position based on the level of risk you will encounter in the trade. Many traders recommend not risking more than 2% of your total funds per trade, but there is no hard and fast rule, as each trader’s risk appetite is different.
To improve one’s overall trading skills
Finally, by continually applying risk management strategies, traders can reduce their emotional decision-making and improve their consistency in their results over time. They can not only avoid large losses, but they can also find it easier to spot adverse situations and avoid them the more they practise trading. This can allow them to become better traders in the long run.
A quick recap of what CFD trading is
CFD stands for Contract for Difference, and CFD trading is the process of speculating on the price movement of an asset in the market to potentially profit from it. When a trader participates in CFD trading, they purchase a contract that allows them to buy or sell an underlying asset, such as a stock, currencypair, commodity, or index.
The trader chooses their position size and can take advantage of margin trading. When they are ready to close their position, they buy a contract taking the opposite position. The profit they earn (or the loss they incur) is the price difference of the instrument between the time when the contract is establishedand when the trader closes their position.
Risks involved in CFD trading
The most common risks involved in CFD trading are leverage risk, market risk, counterparty risk, and operational risk. Let’s look at them in detail.
Leverage risk is one of the main risks involved in CFD trading, which allows traders to use leverage and control a much larger position than they would otherwise be able to when they trade with a small amount of funds at the outset. While the use of leverage can amplify profits, it can also amplify losses if the market performs poorly and goes against a trader’s expectations. This can lead to a significant loss of capital for the trader in a short time span.
Market risk is the uncertainty of the price movement on the underlying asset. In other words, it is the possibility that the market can move against your expectations, resulting in losses. This is because there are no guarantees when it comes to market movements. Even as an instrument has ‘proven’ to perform well historically, it can still take a plunge if it is affected negatively by economic and political events, market sentiment, and other factors.
Counterparty risk is the risk that the person on the other end of the deal – the CFD provider – is unable to meet its obligations. Traders who buy contracts are exposed to counterparty risk. If the CFD provider that they work with is unable to fulfil the contract terms and settle the contract, it can lead to capital loss for the trader.
Finally, there is operational risk involved in CFD trading. This is the risk that there may be technical issues on the trading platform or connectivity issues that prevent a trade from being executed in a timely manner or at all. This can lead to capital loss for the trader.
How to manage CFD trading risks
Knowing what the risks of CFD trading are, it is essential that traders understand how to manage them effectively to ensure they minimise the losses they incur. Some common risk management techniques include:
The first thing you should do is to limit your leverage, if you are a novice trader. This is essential. While many traders view leverage as a gateway to large gains, it can also become a way for traders to lose significant capital if they are not careful. Therefore, have a good idea of your own risk appetite and do not use high leverage if you are not prepared to handle great losses.
Doing proper research
You should always conduct proper research on how the market may move and make an informed decision when entering and exiting markets. When you have a solid idea of what moves asset prices and the trends and patterns it has undergone in the past, you will find it easier to predict how it will behave in the future. Of course, as mentioned, past performance is not a reliable indication of how an asset will behave, and there are no guarantees of profits in trading. However, knowing how to analyse market charts will keep you one step ahead of other traders and allow you to make more informed trading decisions.
Working with a reputable CFD provider
Finally, one of the best ways to reduce your risk when trading CFDs is to work with a reliable and reputable CFD trader. You should always make sure your CFD trader is regulated by the MAS (Monetary Authority of Singapore), which is the country’s central bank and financial regulator. Work with a provider that has strong backing, a long history of experience, and that follows local laws and regulations to ensure your funds are kept safe and to minimise counterparty risk.
The bottom line
CFD trading can provide traders with a flexible and accessible way to speculate on the price movements of a wide variety of financial markets and assets. This makes them very appealing to many traders. However, it also carries risks, and traders should always and carefully evaluate these risks before entering the markets. Set stop loss orders, manage leverage realistically, and never work with any CFD provider that does not follow local regulations.