To successfully trade the capital markets, you need to integrate a risk management strategy as part of your trading routine. Those who do not formulate a risk management plan for products like CFDs or forex will have a difficult time to sustain a profitable account.
Your first task should be to decide, based on your capital, the amount of money you are willing to lose and your profit target on a specific timeframe (daily, weekly, monthly, etc…)
Following this decision and prior to entering your first position, you should formulate a risk management plan, determine your reward versus risk ratio, and understand the leverage you are using by your broker.
Contracts For Difference (CFD)
Contracts for differences (CFDs) are widely traded instruments that allow you to trade several products including equity shares, indices, commodities, cryptocurrencies, and currencies. When you buy or sell a CFD, you are responsible for the difference between your purchase price and your sale price without actually owning the instrument.
The amount of capital you need to post for a CFD will depend on the volatility of the instrument. One of the advantages of CFDs and the reason for its popularity is that you do not need to post the entire value of the security but a partial amount of the overall transaction value.
CFDs are geared to investors looking to speculate on the direction of any security or currency pair and provide an advantage over standard shares or ETFs that are purchased via exchanges. For example, if you are interested in trading shares of Apple stock, the amount you will need to post for a CFD is approximately 5% the amount you would post if you purchase the shares at a stockbroker.
The risk management that you incorporate into your trading strategy should be based on your risk tolerance. Each strategy you develop should be based on a business plan that describes how much you plan to risk as well as the gains you expect. It is important to understand that every trader has different risk tolerance and therefore, every trader must form an independent risk management. For that purpose, it takes time to become a profitable trader as you must realize your trading qualities and flaws.
Risk versus Reward and Profit Factor
Successful traders are aware of the risk they will take on each trade and the reward they will receive prior to executing a transaction. There are two ratios that can help in this process. The first is the reward versus risk ratio and the second is the profit factor.
The reward versus risk ratio is your reward divided by the risk. Successful trading strategies will gain more than they lose. For example, if you win $2 on every winning trade and lose $1 on every losing trade, your reward to risk ratio is 2 to 1. That’s quite simple. For new traders, this ratio can be beneficial. You need to decide on a certain positive ratio and no matter what happens during your trading time, you must apply this ratio.
The second ratio is the profit factor ratio. To calculate this ratio you divide your gross winning trades by your gross losing trades or, alternatively, you multiply the average win rate on successful trades by your winning percentage and divide that number by the average rate on unsuccessful trades times your losing percentage.
Profit factor = (gross winning trades) / (gross losing trades) or = (Win rate x average win) / (Loss rate x average loss)
Catching a Trend
One of the more common steps following forming a trading strategy is to insert technical indicators into your trading tools. The moving average crossover strategy is geared to catch a medium-term trend where you purchase/sell a currency pair or CFD. The reason why it’s important to learn the skills to catch a trend is that in order to be a profitable trader and apply your risk management strategy, you need to know how to earn more than you lose, meaning catching a trend.
The indicator signals you to buy your asset when a shorter term moving average (20-day moving average in this case) crosses above a longer-term moving average (50-day moving average in this case). You would transact the reverse when the 20-day moving average crosses below the 50-day moving average.
The risk management you use when trading a trend following strategy could be one where you lose 3% while looking to gain 10%. For example, you want to make $1,000 and you are willing to lose $300 on each trade.
If you trade 9-times, losing 6-times ($1,800) and winning 3-times ($3,000), you will wind up with a $1,200 profit. The key is to find a risk-reward profile that meets your trading goals. In this example, your reward versus risk rate is 3.33 to 1, and your profit factor is $120.
If you use a different type of strategy, where your winning percentage is higher than your losing percentage, then the amount you lose can be equal to the amount you gain. If you win 60% of the time and lose 40% of the time and you risk $100 on each trade, after 10-trades you will have a gross profit of $200.
As you are confident with the moving average indicator, then it’s time to move forward and learn other indicators such as Fibonacci, Bollinger bands, relative strength index and integrate those into your charts.
Cutting Your Losses and Letting Your Profits Run
One important concept is letting your profits run while cutting your losses. This is especially important for trend following strategies. The risk management strategy you use should incorporate this concept by using a trailing stop loss. This is a dynamic stop loss technique that changes with the market. You can use a percent stop loss when designing a trailing stop or an absolute number. The goal is to hold on to your position until the market reverses. For example, if you purchase the EUR/USD with the goal of making 2% while only risking 1%, once the market rises 1%, you can move your stop loss up to make sure you do not lose the 1% you have as an unrealized gain. As the market climbs, you continue to move your stop loss up until the market reverses and hits your trailing stop loss. This will allow you to maximize your trade while catching a trend.
How to Trade CFDs with Appropriate Risk Management
Prior to making a trade with real capital, you should paper trade to determine if your trading strategy can be successful. Another important risk management concept is to stick with your strategy. Novice traders will often exit positions early especially if they are losing money, not giving the strategy a chance to become unsuccessful. Additionally, it’s easy to become married to a trade, allowing the market to move against you passed your stop level, which can lead to the risk of ruin.
Another important feature of CFDs is that you are using leverage. Higher leverage equals to larger risk. For your trading strategy to become successful, you must know the leverage your broker provides and in particular, the instruments you are engaged with.
Day Trading Risk Management
Day trading is an activity where you plan to exit positions you take by the end of the day. Most day trading strategies are focused on entering and exiting a position intra-day. Before trading any forex pair or CFD, you should evaluate the historical daily ranges so you know how much you can expect to make or lose on any given day. For example, the historical range, from the daily high to the daily low, of crude oil prices over the past 3-years is $0.50 per barrel. Therefore if you are day trading crude oil you can evaluate a daily change based on historical data. Obviously, the volatility is higher for other instruments such as cryptocurrencies.
The risk management you use should be focused on exiting your positions with a profit or loss by the end of a trading day, as well as, figuring out a risk versus reward ratio that will fit the daily ranges of the product you are trading. Meaning, when you are day trading, you must have a daily limit for how much you can lose and although you want to squeeze the lemon in a profitable day, sometimes it’s not such a bad idea to limit your profit.
Additionally, you also want to incorporate slippage and commissions into your trading activities. Slippage is the amount of capital you generally lose by entering or exiting a trade. Commission also include the bid/offer spread your broker provides. If you are trading crude oil and the bid/offer spread is $0.02 per barrel and the slippage when you enter a trade is $0.01, then you need to subtract $0.03 from each trade when you design your trading strategy.
Risk management is an important concept and you should plan out the amount of the risk you are willing to take before initiating each trade. Your risk management style should be based on your financial goals, your risk tolerance and… your personality. Remember, you are paid to take a risk and the reward you achieve will be based on the risk you take. The more you risk the more reward you should expect and the less risk you take can make you a solid trader. You want to design a trading strategy that has a positive reward versus risk ratio and make sure you cut your losses and let your profits run. That’s the main goal.