About CFD Trading Risk Management And Position Sizing

What does risk management in CFD trading mean?

A CFD trading system is usually used together with a system of risk management.

In the previous section we talked about trading systems, in this section we’ll talk about risk management.

Risk management is about how much funds are to be put into each trade to attempt to not risk too much per trade.

For example, for a hypothetical system, you may have found that during backtesting, your system produces x% return, a maximum drawdown of y%, and a maximum losing trades in a row of z.

With leverage you magnify returns or losses , whatever is the result of your system.

For more on leverage, and about using all of it or part of it, see this discussion on use of CFD margin and leverage.

If you follow the system with the same risk management rules you are assuming system keeps performing, hopefully produce similar results in real trading. Note that historical performace does not guarantee future performance. And if and when you do come across a year that has a similar drawdown, or z losing trades in a row, then with proper risk management, you will have a chance to overcome this drawdown.

If on the other hand, you do not have risk management, and you put an excessive portion of your entire float into each trade as an example, you may find that after only a small handful of losing trades, that you’ve lost all of float and cannot continue trading, and thus cannot produce the profits. There goes your ability to make profits in the market because you’re no longer in the market.

Let’s have a look at a commonly used and commonly discussed method of risk management, the fixed dollar trade size, to see an example.

This is not the only risk management method, but we’ll go through this method here, just as an illustration.

It is not a recommendation to use this model. It is to let you know the fact that risk management is a factor to consider in trading.

CFD risk model: Fixed dollar trade size

The fixed dollar trade size model is a model which assumes the use of the same amount of capital for each trade.

As in our example we just mentioned, if you had a leveraged float of a certain amount, you may choose to put a specific amount of funds into each trade, say $x.

To work out how many CFDs to buy or sell when entering the trade, you would take the $x and divide it by the price of the CFD.

For example if the last traded price of the CFD was $7.50, the number of CFDs you’d buy is x/7.5.

Now to work out the amount that is at risk in the trade, you would need to do a different calculation.

The amount at risk in the trade is not the same as the amount you put into the trade, assuming that there is no slippage or that the stock goes through an event such as a stock collapse to zero or a takeover witha sudden change in price. The amount at risk is defined as “how much would you lose if the CFD goes against the direction of the trade, getting you out at the initial stop loss?” (assuming no slippage or collapses or takeovers etc).

To figure this we need to know our stop loss distance, which is the difference between our entry price and our stop loss price.

Let’s say for example, that the price of a stop loss was $5.00, and that we got into that stock at $5.20, which will make our stop loss distance equal to $0.20.

The amount at risk in the trade = (number of CFDs bought or sold) x (stop loss size) (assuming no slippage or takeover or other situations)

= number of CFDs traded x 0.20 in this example

The numbers above are just an illustration of these principles.

So our risk in the trade is $w which is what the loss will be if the trade goes against us and gets us out at our initial stop. To be more precise you’d also include the cost of commission and interest as well.

Note that with this fixed dollar trade size model, although you are putting in $x into each trade, the number of CFDs that you will buy or sell will be different each time, and so will your stop loss size.

Therefore the amount at risk will be different with each trade.

This may or may not appeal to you.

In contrast there is the "fixed risk model", which has variable traded sizes to keep the amount at risk the same or similar with each trade. In this case the trade size will be differeny between trades.

CFD risk management: Compounding trades or profits

There is a related issue of risk management, which is whether or not to compound trades or to compound profits.

Compounding trades means that as your float grows, you will plan to enter a greater number of positions.

For example, if you have a given float and you can be in a maximum of up to 10 trades at once. If your float grows larger, then you’ll be able to take up to more trades at once. In reality it will be more or less than these numbers as the value of your account is updated in real time according to whether you are making profits or losses on your positions as the CFD prices fluctuate up or down.

Compounding profits on the other hand, means that as your float goes up, then the amount of funds you put into each trades also goes up, while the number of maximum positions stays the same.

For example, if you have a given float and you can be in a maximum of up to 10 trades at once. If your float grows larger, then if you take larger position sizes then this is consistent with this model. Again, if you are considering this, you should backtest your results to see that the profits increase and that the drawdown is still acceptable. Typically you can do this strategy up to a certain point when the drawdown gets too big for your liking.

Furthermore, if you’re trading a market that has liquidity issues such as a market that is not huge, then you may get to a point where you are getting more slippage when the trade size reaches a certain size.

So compounding profits may be done, but there are limitations with this type of compounding.

And compounding increases your risk as your exposure increases.

Go on to part 3 of this tutorial on: CFD Order Types: Market, Limit & Stop Orders


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