Understand the dangers of trading CFDs before jumping on board
If you are involved in trading Contracts for Difference (CFDs), and you read the papers, then you would have come across some CFD articles suggesting that trading CFDs is just like gambling.
In this article, we’ll take a look at the reasons behind such a damning reference and explain clearly how to ‘remove the gambling’ in your CFD trading.
Click play on the video below.
Las Vegas & the rich and famous
When people think of gambling, visions of Las Vegas, roulette tables and the rich and famous come to mind. Next, you have the horse races and events like the Melbourne Cup which stops the nation, and over $250 Million is invested (aka gambled) on this one race alone.
Yes, Australian’s love to gamble and recent reports indicate that 80% of Australian’s gamble which represents the highest rate of gamblers per capita in the world! Australia also wins the title for the most poker machines per capita in the world. We sure are off to a flying start, aren’t we?
For many years seminar spruikers have indicated that Australian’s are the largest owners of shares per capita in the world and most recently CFDs have exploded on our market.
It seems to be true that Australian’s love shares and have taken to CFDs like Tiger Woods to the fairways and knee surgery.
Time to trade your Holden for a Porsche
The people who suggest trading CFDs is like gambling, usually come from a history of long-term stock investing where solid blue chip companies paying attractive dividends rule the portfolio.
Many traders would suggest going from trading stocks to trading CFDs is like trading in your Holden Barina for a twin turbo Porsche 911.
If you are an inexperienced driver, then jumping behind the wheel of a high-performance car could be deadly. Just like those trading CFDs with little to no experience.
Stock Markets worst result in 26 years
If we stop to consider the recent market correction, which experts have identified as the worst yearly performance of the Australian All Ordinaries index in some 26 years, can we even be safe investing in solid blue chip companies like National Australia Bank, AMP or ANZ bank?
Many Self-managed super funds and accounts of investors holding on to these ‘Blue chips’ have lost anywhere from 15-45% since their November 2007 highs.
Calling the buy and hold strategy gambling would be a massive mistake on my behalf because without knowing the time frame or risk tolerance of the investor would mean I’m just making a huge generalised statement.
So too with CFDs in that calling CFD trading gambling without knowing how the product can be safely used, the trader or investors’ time frame and risk tolerance then this statement too would be a huge generalised statement.
So why do people consider CFDs to be gambling?
First and foremost the biggest offender is the fact that you can lose more than what you start with when trading CFDs.
For example, you might have $5,000 in your CFD account, but your CFD Leverage will allow you to trade $100,000+ worth of most blue chip shares like BHP.
If BHP falls 6% in a couple of days or perhaps even in one day as it did in January 2008 (gapped over 6% overnight), then you would have lost around $6,000. Considering you only have $5,000 in your account you now face a small problem.
You’ve just wiped out your trading account and now owe $1,000!
So not only are CFDs dangerous in the wrong hands but it’s worse than gambling because you can, in fact, lose more than what you start with.
At least when you journey off in your finest suit or beautiful dress to the race track, the most you can lose is the money you start with.
So yes, when people trade Contracts for Difference (CFDs) with reckless abandon and don’t take into consideration how to effectively use their CFD leverage then problems can arise, and CFDs can assume a gambling like nature.
How to make 30% returns without breaking the bank
Let’s say you have backtested your trading system and it returns 10% per annum with no leverage. Not exactly an incredible trading system and certainly won’t win you portfolio manager of the year but nonetheless a sensible plan to extract steady profits from the market.
Not exactly an incredible trading system and certainly won’t win you portfolio manager of the year. But nonetheless, a sensible plan to extract steady profits from the market.
What happens if you then trade that at three times leverage? This means if you start with $10,000 cash in your CFD account, you take positions that do not exceed more than $30,000 in total.
You then continue trading your 10% return per annum system and voila you have now achieved a return of around 30% on your cash.
You just made 10% on $30,000 which is a 30% return on your cash outlay of $10,000.
So the real trick to trading Contracts for Difference (CFDs) is controlling your leverage and understanding your CFD Risks implicitly. In fact, it is sensible to trade CFDs with little to no leverage while you are finding your ‘feet’ in the market.
So before you put down the deposit on that Princess motor yacht, start very small and trade well within your limits.
Any investment carries risk, but successful traders and investors understand risk is essential to earn a reward for their efforts.
How to remove the ‘gambling’ from your CFD trading
- Start small – open an account with $5,000 or less;
- Develop a trading plan that suits your investment/trading profile;
- Identify your entries, exits and use appropriate risk management;
- Commit to taking the first 20 trades your system generates with very small risk on each trade (1% risk of trading capital maximum);
- Identify if your trading system has an edge and is worth continuing to trade; and
- Continue trading or re-evaluate your trading system
Overcoming Fear and Greed
Countless Trading books have been written on overcoming the psychological aspect of trading the markets. Overcoming Fear and Greed are by far the most important elements to long-term success. Greed alone is usually what drives people to gamble when trading Contracts for Difference.
Greed in CFDs is disastrous and can have the potential to wipe out your trading account. But then again, greed in most financial instruments will cripple your long-term wealth creation plans.
The problem with CFDs is the easy access to trading brokers and their platforms either online, over the phone or direct through your mobile phone.
Couple this with the incredible leverage you get access to (from 10 to 100 times your starting balance), and you can see why greed can be the silent and willing killer to any trading account.
“Contracts for Difference (CFDs), Forex, Options or Futures are not risky,
it’s how the trader uses them that makes them risky or not.”
Having watched many traders succumb to the greed of high returns through trading, it has become clear that controlling the amount of leverage you trade with in your CFD account is paramount.
The risk is very closely correlated to return, so play it safe, keep the leverage on your CFD Trading to a minimum, trade your system confidently and enjoy a long and rewarding association with trading Contracts for Difference.