More often than not, CFD brokers and dealers automatically provide a free stop-loss order service to their trading clients. This is to encourage people to limit their losses on this very risky leveraged trading instrument. A stop loss on your CFD is exactly that, a tool for the trader to limit their trading losses. It is up to the trader to self regulate their usage of this tool and any trader is encouraged to utilise the tool in their trading systems.
So How Does a Stop Loss Work?
For example you have opened a long position on XYZ stock at $10, but you only want to limit your trading liabilities to 50 points so you can set a stop loss on your CFD trade at $9.50. So if your trade goes sour, the stop loss order immediately executes a sell to exit your long position.
However, these is a disadvantage and also risk to using a stop loss. For instance, if the market is having a stormy day at sea, that is, an over-volatile market where the underlying stock under the CFD is spiking up and down, you may find that you are stopped out too easily if you have put your stop loss order too close to the action. The risk when using a stop loss is when the market gaps and the stock just doesn’t trade at your stop loss limit. If you think about it – it’s a VERY BIG risk. However an advantage to the stop loss order on your CFD is that if gives you the discipline to follow a system as it automatically takes you out a trade which at some point in time you expected to make you a profit because it was trending to some sort of pattern. That is only an advantage if you resist the urge to continuously move the CFD stop loss.
So How Does It Work Making Profit From CFD Trading?
Let’s use a case study to illustrate how CFD’s (Contract’s For Difference) work. So lets take UK listed Tullow Oil (TLW) and assume the price is at £50. After our technical or fundamental analysis we have decided whether we want to sell (going short) or buy (going long) the stock (or the CFD). Say we go long (buy the stock) and decide to risk £1 on each point of fluctuation in the share price. (A point is worth a cent in this context) This means for every cent that the TLW shares move, the trader either gains or loses £1. Now the way you decide this £1 risk per point depends on the leverage (CFD dealers usually have a 3%, 5%, 10% or 20% options available on the amount of leverage) and the size of your contract with your CFD dealer. So if the WPL shares have gained 10 pence and want to take profits your profit would be 10 x 1 = £10 or if the share lost 10 cents then you lose £10.
So to take this example of how CFD’s work to the next level, still assuming the £50 underlying share price for TLW. Say we have £10,000 (ten thousand pounds) to invest in the trading game. Say if your CFD broker has a 5% margin required (the leverage amount) for TLW. 5% of £50 is £2.50 so you need to deposit at least £2.50 per share with your dealer to trade TLW CFDs. The reason why I say at least is because the shares may fluctuate since these CFDs are mark to market which means, at all times you trade CFDs you must maintain this 5% margin level or else the broker make liquidate your position. So with the £2.50 per share margin requirement you can buy 4,000 (£10,000/£2.50) shares or £200,000 worth of exposure to TLW. That’s the power of leverage. And remember – it’s a double edged sword.