It is vital that you understand the risks involved before you start trading CFDs. This article will explore volatility, leverage, stop-losses and risk tolerance, to explain what you need to know in order to begin.
Let’s make it clear from the start: Contracts for Difference (CFDs) are high-risk products. It is, therefore, important that you understand both how the product works and the risks involved before you get started. Keep reading to find out what you need to know.
Trading CFDs: Explore the risks and how to manage them
You are strongly advised to watch this 30 second video. It is highly likely you could lose money without a clear understanding of the risks involved with these complex products.
Suitability Checklist
Unless all the following apply, CFDs are not suitable for you. To trade CFDs, you should:
- Have trading knowledge and experience
- Have sufficient time to actively manage your open CFD trades
- Understand how leverage works
- Have a high tolerance for risk
- Trade only with money you can afford to lose
Before trading CFDs, consider each of these points in more detail.
Trading knowledge and experience
CFDs are not for those who have never traded before. You should only trade CFDs if you already have some prior investment or trading experience.
Furthermore, before trading any CFD, you should also know how the market in question works. Consider looking back at historical price movements and, before placing a trade with real money, try out your strategy first with virtual funds using a demo account.
Have sufficient time to manage your positions
Passive investing, such as putting money into a unit trust or an index tracker, puts less of a daily burden on you to manage your risk. Trading individual instruments with CFDs requires you to constantly monitor how your trades are faring, so that you are aware of any gains or losses as they occur. You may need to act swiftly to protect your capital.
Understanding leverage
Leverage amplifies your potential gains or losses relative to the amount of money you are depositing. This increases the risk compared to conventional investing. It is important to understand how leverage and margin works, and fully comprehend the risks associated with it.
If you don’t take a hard look at risk, it will take you.
Larry Hite, hedge fund manager and pioneer of computerised trading.
Risk tolerance
We are all different, and different types of investors will have different levels of risk appetite. If you are someone with a low tolerance for risk, CFDs will not be for you and you should consider lower-risk investments instead.
Size of risk
There is a balancing act between risk and reward. If you have zero exposure to the stock market or a commodity price, then these instruments offer you no risk; you cannot profit from changes in value in these markets in such a circumstance. In other words, reward goes hand in hand with risk.
Tip: Take on a sensible level of risk with which you are comfortable, without overly restricting your potential for profit.
Furthermore, given the risky nature of CFDs compared to unleveraged investments, your risk capital for CFDs should only be money that you can afford to lose.
Stop-losses
All positions with eToro automatically have a stop-loss. You can choose to move this to a level of your choosing, allowing you to manage your money. You need to be aware that when a stop-loss level is hit, you automatically close your position out at the best price currently available in the market. In fast-moving markets or if prices gap, this may mean a position closes at a level worse than your stop-loss.
Tip: The closer you place a stop-loss, the less you are risking, but the more likely price fluctuations will knock your trade out.
Volatility
The propensity for a security to vary in price is known as volatility and it is considered a metric of risk. Some stocks have a tendency to make larger oscillations in price compared proportionally to the stock market as a whole. We would describe these as high volatility stocks. A low volatility stock would tend to make comparatively small price movements.
The more volatile an instrument, the quicker the price may move against you, so bear this in mind when planning your trades.
Final thoughts
As we have seen, there are inherent risks whenever you trade CFDs. After reading this article, you should understand what these are and be able to make an informed decision about whether CFDs are a suitable way of trading for you.
Visit the eToro Academy to learn more about CFDs and risk management.
Quiz
FAQs
- How can I assess the historical volatility of a financial instrument?
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By using a charting package you can gain an overview of how much price has moved with time in the past.
- If a stock has shown low volatility in the past, does that mean it will have low volatility in the future?
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Not necessarily — past behaviour cannot be relied upon to indicate future behaviour.
- Are stop-loss levels guaranteed?
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No, stop-losses are not guaranteed. Under certain conditions, it is possible that a position may be closed at a worse price than its stop-loss level.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.