How to manage your risks in CFD trading?
Risk management is critical in financial markets, particularly in Contracts for Difference (CFD) trading. To manage risks effectively, you need to plan carefully, stay disciplined, and continuously monitor the market. It's vital for safeguarding your capital, reducing losses, and ensuring the stability of funds. In this article, we'll grasp the basics of risk management: leverage monitoring, using stop-loss and take-profit orders, and dealing with psychological factors.
Leverage Monitoring
Why use margin trading?
Margin trading enables you with the availability to participate in the market with small funds and to hedge. Using leverage, even small price fluctuations in an asset can yield significant gains relative to the total position value.
Remember, while margin trading can amplify profits, it also magnifies potential losses. Although these losses cannot exceed your initial investment amount due to Negative balance protection, trading on leverage increases the risk of a margin call, requiring additional funds to maintain open positions. Also, broker can close your positions if you don’t add any funds to support trades.
It's important to recognize that margin trading isn't obligatory for all investors. Leveraged instruments are often popular among experienced traders who understand their risks and are adept at managing them. Novice traders or those who prefer conservative investment strategies, might steer clear of margin trading or seek advice from an independent professional.
How to manage risks
By starting to trade with moderate leverage, you can reduce potential losses and gain more time to respond to market changes. Before entering a trade, conduct a thorough market analysis and develop a clear action plan, including entry points, exit points, and stop-loss levels. For instance, if the market volatility is high and you want a safer, slower change, using the lower leverage might be a better decision.
Diversification
Asset Correlation
Investing in assets that have a high correlation with each other doesn't reduce your risks because they may both decrease in price simultaneously.
Over-diversification
If you spread your funds across too many assets without conducting sufficient analysis, you may find it challenging to monitor all your investments adequately.
How to manage risks
- Per trade risk limit: Limiting exposure on a single trade can be helpful risk management practice. Let's assume that a 2% limit is set for the trade. If the trade generates a loss due to unfavourable market conditions, manual closure at 2% or the stop-loss order set at this level prevents any further capital loss. For example, for a €10,000 deposit, the maximum risk per trade should not exceed €200.
- Aggregated risk control: For example, the total risk of all open trades does not exceed 5% of the deposit. This means the collective risk for multiple positions should remain within this limit. For the same €10,000 deposit, one might consider limiting the total risk to €500.
Using orders
Stop loss
is an order for the automatic sale of an asset when its price reaches a certain or closest immediate level, acting as a loss limiter. Its main purpose is to limit potential losses on a position.
Take profit
is an order a trader places to sell an asset when its price reaches a specified or closest immediate level. The goal is to secure profit when the asset reaches a desired price mark.
Why use stop loss and take profit?
- Loss management: A stop loss helps you control and limit potential losses by automatically closing losing positions, preventing further losses.
- Profit protection: A take profit allows you to predefine and secure a profit level, minimizing the risk of losing already earned money due to unforeseen market changes.
Psychological Control
Fear of Missing Out (FOMO)
FOMO in trading manifests when you see the market moving and feel you must immediately enter a trade to avoid missing out on a profitable opportunity. FOMO can lead to impulsive decisions, entering the market without proper analysis, or taking too much risk.
How to overcome FOMO?
- Stick to your strategy: Develop a trading plan in advance. Don't deviate from your strategy just because you see market movements.
- Limit exposure: Avoid monitoring the market 24/7, as it may intensify FOMO.
- Accept missed opportunities: Missed opportunities are part of trading; there will always be new ones.
Gambling addiction
Gambling addiction occurs when trading becomes uncontrollable and resembles gambling. Traders who suffer from gambling addiction often ignore risk management and lose more money than they can afford.
How to prevent gambling addiction?
- Set clear limits: Determine how much money and time you can spend on trading.
- Self-analysis: Regularly review your trading activities to determine if you are turning trading into gambling.