Stop-Loss Exit Points: A Necessary Safety Net for CFD Traders

CFDs are widely regarded as the tool of choice for short-term traders today because it offers the trader the possibility of making a profit on small moves in a stock, currency or index.

The Power of Leverage:

The ability to make a profit from small percentage moves on a stock, currency or index is because of one thing: the power of leverage. The leverage level offered by the CFD provider magnifies the underlying movement of the stock, both positive and negative.

Risk in Leverage:

Because of the mechanics of leverage, traders need fully to appreciate the risks and costs involved. Profits and losses are based on the full transaction value once the trade is exited. This means that on the bright side, profits can be significantly larger than the initial margin required to establish the trade. On the negative side, the loss can also be much larger than the original cash outlaid when entering the trade.

For example, a trader going long $10,000 of a share that has a collateral base of ten percent (10-times leverage) will only be required to place an initial margin of $1,000. This means a move of 10% in the share price will mean a 100% return or loss on the initial capital.

Obviously the downside is the problem. The answer: establish a stop loss level where the trade is exited automatically if the trade goes against the trader.

Stop Loss Vs Guaranteed Stop Loss (GSL)

Because of the power of leverage escalating the loss on a losing trade, stop-loss levels are seen by most traders as an integral part of their trading plan. A stop loss order allows the trader to set a price, which if reached will automatically trigger a sell order (for long positions) or buy order (for short positions) to close their current position. With a simple stop loss, if the share or index breaches the set stop loss then the order will be executed at the next available price at the time of dealing. "At the next available price" may mean that  the exit order is executed at price lower than the stop loss price in the case of a long position, or more than the stop loss price in the case of a short position.

However, the use of a guaranteed stop loss on share and index CFDs overcomes this. As it suggests, this is a stop loss order that is guaranteed to be executed at the price the trader specifies, even if the price of the underlying share or index makes a sudden movement and never actually trades at the price that specified. This means the position will still be closed at the chosen price. This may not be the case with a simple stop loss.

On the negative side of the ledger, the cost of establishing a GSL can be so high that it can reduce previously winning trades to break even of worse, a loss. As such, if the trader employs a GSL, trading history suggests that they are more appropriate to highly volatile stocks such as those that frequently gap or prone to large intra-day movements. Amongst others, this includes low-volume stocks, middle-tier mining stocks and large one-commodity commodites such as gold and oil companies.

A Sobering Example of the Importance of Stop-Loss Exit Points:

The so-called luck of the Irish ran out for a group of CFD traders on the Emerald Isle a few years back. At least $50 million was lost in minutes by private clients of Irish stockbroking investors in pharmaceutical company Elan. The traders had staked money on CFDs, which are not regulated by the Irish Financial Services Regulatory Authority (IFSRA), so their losses were amplified when Elan's share price collapsed by 70%.

Elan was among the most-traded shares using CFDs in Ireland. This debacle unfolded when Elan announced it was suspending its multiple sclerosis drug Tysabri, raising questions as to whether CFDs should have been promoted for use in an underlying share as risky as Elan.

Some senior broking sources have confirmed that Irish private investors had staked at least $15 million on CFDs based on the Elan share price rising ahead of the crash. The leverage of CFDs, therefore, means those investors are facing losses of at least $50 million, given the 70% share price collapse.

It was actually the second time in just over a year that CFDs have been responsible for amplifying the losses in an Irish share price slide. Investors trading CFDs raised regulatory concerns previously when Ryanair shares fell following the airline's profit warning.

Risk Profile:

Every traders risk profile is different as is every stock's risk profile. As the Irish examples testifies to, the more speculative the stock, the higher the inherent risk associated. As such, those CFD traders with a more aggressive risk profile, trading these more risk-prone shares suggest a GSL is mandatory.