Tips On CFD Trading: About CFD Trading Risk Management And Position Sizing

What does risk management in CFD trading mean?

To generate profits in CFD trading, you need a good CFD trading system together with good 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 ensure that you will survive the losing trades easily, and continue trading to make the returns that your trading system was designed to make.

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.

If you follow the system with the same risk management rules you will, assuming system keeps performing, hopefully produce similar results in real trading. And if and when you do come across a year that has say a y% drawdown, or z losing trades in a row, then with proper risk management, you’ll be able to overcome this drawdown AND make the return for that year.

If on the other hand, you do not have risk management, and you put say a large portion of your entire float into each trade as an extreme 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! Thus 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 method of risk management, the fixed dollar trade size, to give you an idea of how money management works.

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

CFD risk model: Fixed dollar trade size

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

As in our example we just mentioned, if you had a leveraged float of $100 000, you may choose to put the same 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. 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?” 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 in this example, that our stop loss was $7.30, and that we got in at $7.50, which will make our stop loss distance equal to $0.20. And let's say that the number of CFDs is 1333 just as a hypothetical number.

The amount at risk in the trade = (number of CFDs bought or sold) x (stop loss size)
= 1333 x 0.20
= $266.60

The numbers above are just an illustration and is not a recommendation or a part of any particular system.

So our risk in the trade is $266.60, 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.

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.

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