Reducing your Risk While Trading CFDs

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Every trader has strengths and weakness. Some are good holders of winners, but may hold their losers a little too long. Others may cut their winners a little short, but are quick to take their losses. As long as you stick to your own style, you get the good and bad in your own approach.” – Michael Marcus.

Managing your exposure to risk is a vital, but undervalued aspect of successful online financial trading. The fact of the matter is that you can work hard at trading successfully and building up your nest egg, only to lose it all on a couple of losing trades.

At the outset, it is important to note that the higher the risk, the higher the potential profit. However, the risk of losing your entire investment is equally high. Thus, it makes sense to implement trading strategies that reduce your risk profile.

What is a CFD?

Before we look at several risk-reducing strategies, let’s look at a succinct definition of what a Contract for Difference (CFD) is.

In short, a Contract for Difference is a legally-binding contract between two parties. In our example, a CFD is between a trader and a broker. Its sole purpose is to allow the trader to leverage an asset’s price volatility without having to purchase large volumes of the asset. This is why CFDs are known as leveraged trades. They allow an investor to leverage the price movements on a large trading volume without needing to take ownership of the linked asset.

When opening a CFD trade, the trader and broker agree to the opening price, size or lot, and the closing price. If the price moves in the direction that the trader predicts, the broker pays the trader the difference between the opening and closing prices and vice versa.

Finally, it is worth being cognisant of the fact that, because of its need for volatile price movements, CFDs are well-suited to underlying assets such as Forex and cryptocurrencies.

Risk-reducing CFD trading strategies

Now that we have an understanding of the basics of a CFD and how it operates, let’s take a look at several risk-reducing trading strategies:

Know your trading style

It is critical to know that you, like every other trader, has strengths and weaknesses. As Michael Marcus states in the quotation mentioned above (and echoed by Jones Mutual financial analysts), you might cut winning trades short, and leave losing trades too long. On the other hand, you might not let winning trades run for long enough. The fact of the matter is that no one places winning trades all the time. Therefore, the salient point is that if you know your trading style, you can make sure you stick to your trading style because you will be true to yourself. Also, you will be able to learn new investment skills and strategies to improve your trading knowledge and expertise.

Hedging

One of the most conservative trading strategies is known as hedging. The best way to explain how hedging works is to cite a small case study:

Sometimes an asset’s price volatility makes the price swing wildly in all directions. For example, currently, South African Rand (ZAR) along with all emerging market currencies is losing heavily against the United States Dollar (USD). However, it goes through moments where it swings back just as wildly as its dropping. In this case, it can be tough to predict which way the USDZAR price will move.

Thus, you can protect your investment from wide-scale losses by opening two USDZAR trades concurrently. One is a Buy trade, and the other is a Sell trade.  Depending on which way the price moves, these two trades will cancel each other out. In this way, you can protect your investment from substantial losses.

Stop Loss and Take Profit

When you open a trade, it is critical to set a Stop Loss point as well as a Take Profit point. In short, a Stop Loss point will automatically close a trade at a specific value below the opening price. On the other hand, setting a Take Profit point will automatically close the trade once it has reached a certain level of profitability. The trick is not to set a Stop Loss or Take Profit point that is too high (or too low) to allow for a certain amount of price volatility without the trade automatically closing.