Stop-Loss Exit Points:
A Necessity for CFD Traders
What are CFDs:
It is 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 theory states that a Contracts for Difference (CFD) is an agreement between an investor and the CFD provider to settle the difference in cash between the price at which the CFD trade position is opened and the price the CFD trade is closed..
What this means is that the CFD trader need only be concerned with the difference between the buying and selling price.
CFDs are set up to follow the share price of a company, an index or a currency.
Profits can be made by buying a stock, currency or index you expect to appreciate or selling a stock, currency or index you expect to decline in value. There is a catch.
Leverage:
Trading CFDs can offer you the exposure required to make a profit from small percentage moves on the underlying move in the stock, currency or index because of one thing: the power of leverage. The leverage level offered by the CFD provider magnifies the underlying movement of the stock, both positve and negvative.
Risk in Leverage:
CFDs are promoted as an ideal short-term trading tool. However there are risks. Potential traders need fully to appreciate the risks and costs involved. Because profits and losses are based on the full transaction value, they can be significantly larger than the initial margin required to establish the trade.
For example a trader going long $100,000 of a share that has a collateral base of ten percent (10-times leverage) will only be required to place an initial margin of $10,000. A move of 10% in the share price will mean a 100% return or loss on the initial capital.
Stop Loss Vs Guaranteed Stop Loss (GSL)
Because of the power of leverage escalating the loss on a loosing 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. This may mean the order is executed at less 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 as to make a winning trade unprofitable, or push a normal winning trade back to just break even. They are more appropriate to the low-volume stocks or middle-tier mining stocks that gap a lot. This also includes one-commodity stocks such as gold and oil stocks.
A recent Irish example:
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. I
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 stocks 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 suggests a GSL is mandatory.
