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Expert Answers to Biz Questions
Listen in! Pick up some expert advice to a reader's question that we selected from CyberSchmooz.
Develop a Successful CFD Trading Plan and Mitigate Risks
New financial trading products have traditionally seen a very low rate of success. However, occasionally, a new product comes along and fires the imagination of investors and becomes a huge success. CFD (Contracts for Difference) is one such product that has captivated investor interest and spread across the global financial markets. CFDs originated in the late 1980s in response to demands from institutional traders and hedge funds to short stocks without having to undergo the process of buying and owning the stock first. The credit for creating the first CFD contract is attributed to the derivatives team at Smith New Court, a market maker in listed securities on the London Stock Exchange (LSE). Until the 1990s, institutional investors were the sole beneficiaries of CFDs until Gerard and National Intercommodities provided retail stock traders with the opportunity to trade CFDs on LSE. With the attractive attributes of CFDs becoming clear, a number of European and UK institutions joined the CFD marketplace. However, CFDs gained immense traction following the global financial crisis of 2008 when investors all over the world started endorsing a product that allowed them to do away with the risk of owning the shares.
Understand how CFDs work and invest based on your needs
CFDs allow investors to benefit from the change in the value of an asset without having to own the underlying asset, which has led to a dramatic rise in their popularity. Yet another attraction is that, with CFDs, you can trade across asset classes — forex, commodities, and options, expanding the window of opportunity. However, the danger is that a CFD is a complex instrument and uninitiated investors could risk losing money due to high leverage. It’s a crowded market out there and new brokers and websites are springing up every other week, trying to capture investor attention with fancy promises and features. Very few platforms have the courage to warn investors that they could lose money if they do not understand CFDs properly. Therefore, to mitigate the risk of losing money, the solution is to clearly understand the mechanics of CFDs and prepare a trading approach.
How a trading strategy will help
The overarching goal in CFD trading is to make money in all markets. Hence, investors should develop a well-structured trading strategy that allows them to allocate a set amount of capital for CFD trading and determine the risk in each trade. In a volatile market, investors should dial down the risks per trade and adjust them based on the perceived market volatility. A well-structured trading plan is a self-regulating mechanism that allows you to define the risk threshold and operate within those parameters. In the absence of a trading plan, a CFD trader is likely to exercise ill-considered choices with regard to trade entry and exit points that may adversely affect trading profitability.
Building a trading plan takes time and patience. To start with, you should acknowledge and understand what type of market participant you are so that you can establish the parameters within which you will operate. CFD traders should understand the prevailing market conditions and prepare a plan based on those conditions and incorporate enough flexibility in the plan should market conditions change abruptly. The trading plan should have a clear overall trading objective, preliminary preparation, and well-defined trading methods and risk parameters. The main objective in preparing a trading plan is that you leave very little to chance. With a very good trading plan in place, you will define your overarching objectives and the timeframe. Based on the plan, you will build a portfolio of stocks or other asset classes that fit into the framework of your objectives. The time you have spent on understanding the market, the specific stocks and the factors that could act as negative or positive triggers for those stocks ensure that you are well prepared for those events and nothing will hit you as a shock.
Preparing a trading plan ensures that investors understand the market and are equipped with the required market knowledge and information that help them in devising a portfolio. For instance, if you are preparing a trading plan for equity CFDs, you will acquire all the information on corporate events, earnings calendar, and market expectations for the stocks in your portfolio. Analyst reports and updates will tell you if a company is likely to make a bonus/rights issue or a buyback if it is sitting on a cash pile. Such information will prepare you to take the right trading decision at the right time. Further, you will also study the performance of stocks in your portfolio vis-à-vis its peers so that you know when you have to switch a stock. In summary, a well-defined trading plan has all the attributes that will mitigate risks and make your portfolio robust.
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