Risk Management 1: Manage your open positions ‘” Do not leave them for too long
CFDs are not free lunches ‘” CFD providers make nice profits from several ways ‘” and one way is from financing cost. This means, the longer you hold on to your positions, the more interest you will be paying.
We are now in a low-interest environment, but this does not mean it will be staying that way for a long time. Indeed, given the way the market is rebounding at moment, we could be heading for a new cycle of rate increases very soon.
In addition ‘” the interest rate is based on your CFD position, not on the purchase price ‘” this is a major difference between margin lending and CFD.
$100,000 portfolio based on margin lending, growth at 15% assuming interest is 9% p.a.
Year 1: $100,000 Interest payment: $9,000
Year 2: $115,000 Interest payment: $9,000
In the case using CFD, this will be very different; the interest will go up to $10,350 instead of $9,000 for the same portfolio; because interest is calculated based on your portfolio value at the time; and not on the initial investment. This can have a significant impact on your interest payments.
Risk Management 2: Ensure you are not Over Geared
CFD is a gearing instrument; I know that from beginning and have been managing it cautiously to ensure I do not over-gear myself. It is a risky instrument and people have suffered big losses from them.
Let me go through a number of live examples that has happened to my fellow CFD trader friends:
First Case: My friend was a university student, to be honest, he should not be allowed to trade CFD in the first place, but these days, you can sign up CFD trading account with your credit cards!
He started with just $2,000, he was unemployed, he did not have much income, the money was basically from his parents for his tuition fees.
He did well in the first month, made $500 from just one quick trade, that was a good return for $2,000, but things started to go down, and he had over-leveraged himself, and again ‘” made fundamental mistakes, where were:
- Unwilling to cut loss and let it accumulate, the loss soon accumulated to $3,000 which was over his $2,000 deposit! His portfolio expanded to $10,000, but if he sold out his portfolio, he would still to pay for the differences.
- No short sell positions to cover his losses ‘” again, bad problem, markets moved up and down at the time.
I know many of you will find this situation familiar, but please, make sure you do not put yourself into “over-gearing” mode ‘” for some people, $2000 means a lot, for others, $2,000 is their pocket money for a day.
Make sure you understand your financial situation, if you can only afford to lose $2,000 ‘” my advise for you would be do not touch CFD at all, and should start saving small instead of gambling around your last life-line.
Second Case: For a completely different case study, my friends were actually directors of a listed fund; you would thought these folks would know how to manage their personal monies well. The have used the money gained in the money markets to set their own private equity funds after all.
I was so surprised when I saw their names on web that the company was placed into administration, these guys were the one showing off to me that they made $150,000 a year just by flicking their fingers!!
What I then found out they had “Triple-Deck Margins” ‘” they had not assets, no house, no real shares, nothing, everything was borrowed against one another.
What eventually happened was still unclear to me ‘” but basically, they used margin lending to buy into stocks, then used these stocks to set up a line of credit from now default Opes Prime, and then used the fund to trade CFDs.
The portfolio for one particular guy quickly ballooned to $800,000 in just one year, and he lived like a king, only, we found out it was really Emperor’s New Groove ‘” in his assets and liabilities, you would see truckloads of debt and he actually held not even one actual stock!
The guy was put out of business within one month, and not even the hardest month we then went through in October to January ‘” the market went down by about 10% for the month, which was really nothing ‘” and that had put him completely out of market.
Risk 3: Stop Losses Please, no one is going to keep an eye for you!
I have burnt a lot of monies due to greed and stupidity ‘” I made the kindergarten investment mistakes by ignoring the importance of stop-losses. Please, do not be as foolish as I am.
If you are like me, a busy professional running his own business or working for someone else during the day time ‘” you will know it is impossible to keep an eye on these investment activities.
Unlike margin lending, where the margin lenders will keep an eye on your positions, the leverage ratio (LVR) is also much lower, some as low as 30% or 40%, and they do not even lend to many small to mid cap stocks.
If a share price has dropped so much in a day, you will get a phone call from the margin lender asking to exit or top-up. In the way, this actually protects your downside.
I know what you are thinking when you read this “But am I not missing the upside if the index or the stock rebounds the next day” ‘” that is precisely what I thought and ignored stop-losses.
The fact is, you have trading opportunities everyday, missing out 1 or 2 trades do not matter ‘” you can always clear out the stop loss and re-enter the order again ‘” but at least your loss is limited.
Most of the CFD platforms have excellent stop-loss systems built in ‘” I usually put in 5% stop loss as the minimum, sometimes, I may use 7% for a more volatile stocks.
Recently, I ignored my own advices again and did not put stop losses on my short positions ‘” the losses have now jumped to 20%, and I have to close them now at a much higher loss ‘” the stupid “Greed gremlin” keeps coming up into my mind every now and then.
With stop losses and also limit orders where you can set profit-taking targets are really 2 good ways to manage your portfolio in CFD.
Again, we are not talking about holding on to a long term portfolio but a trading portfolio, so quick and efficiency traders are essential to ensure your portfolio is protected all the time.