The derivatives market is huge. It trades on more than 50 organised exchanges across the world, with North America and Asia Pacific being the biggest markets. It is estimated that the derivatives market is worth more than $1 quadrillion. Some analysts even believe that the size of the derivatives market is over 10 times the total GDP of the world.
Among financial derivatives, one of the most common are contracts for difference or CFDs. CFDs can be used to trade almost any financial asset, including stocks, and offer multiple benefits, such as high leverage, access to the global markets from a single platform, no shorting rules, and no day trading requirements.
Despite the multiple benefits, however, trading stock CFDs is not without its share of risks. So, here are 5 golden rules to follow when trading stock CFDs.
Invest in What You Know and Understand
Although taking the CFD route might seem less risky than trading stocks directly on exchanges, it is always a good idea to trade stocks that you are familiar with and understand what makes their value rise and fall. For this, you need to do your research. Find out what moves the stocks you are interested in.
Experienced traders track geo-political and economic factors, company earnings reports and world or domestic events that could help or hinder company/stock performance. Needless to say, it’s a good idea to stay abreast of financial news and events across the world.
When identifying which stocks to trade, it is useful to understand the difference between defensive and cyclical stocks. Defensive stocks usually belong to companies whose performance and profits remain comparatively less impacted by changes in economic conditions. Some examples of these companies are those that provide essential products and services, such as pharmaceuticals or food.
On the other hand, cyclical stocks belong to companies whose performance, and therefore, profits, are sensitive to changes in the economic conditions. Some examples of these stocks are real estate and automotive stocks. Once you know the difference, it becomes easier to track the economic and other news events that are likely to impact share price movements.
Trading History, Volume & Volatility
A robust online trading platform that offers powerful technical analysis tools can help you review charts and other stock data to establish a stock’s historical performance. It could help you identify patterns in price movements, whether there is any seasonality effect and even predict future price movement.
Apart from historical price data, it is also important to keep track of trading volumes. Trading volume is an effective indicator of the health and strength of a stock. Volume, in this case, is measured in terms of the number of shares and futures contracts traded during a given timeframe. You can choose indicators that use volume data to look for patterns in stock performance, as well as the current interest for a specific stock in the market.
Understanding how volatile a stock tends to be can be very useful in identifying trading opportunities. While greater volatility means more trading opportunities, it also means higher risk. Traders looking at taking short-term positions, in the hope of earning quick profits, might prefer stocks that are more volatile.
Discipline vs Emotions
Traders are only human, which means that emotions could colour trading decisions. Emotions like fear, greed, overconfidence or lack of self-confidence could wreak havoc on trading decisions. The good news, however, is that there are plenty of tools that can help keep emotions at bay.
The first such tool is a trading plan. A trading plan gives you a clear idea of what, when, why, and how you should trade. It takes into account your trading goals, risk appetite and trading style. With a demo account, you can test your trading plan for efficacy before applying it to live markets. However, remember to stick to your plan, with discipline and patience, regardless of what your emotions tell you to do.
Another way to ensure that emotions do not play a role in your trading decisions is to use automated trading tools, such as Expert Advisors. With such tools, you determine all the parameters beforehand and the trading robots take care of entering and exiting positions based on these parameters. They are not subject to the human frailty of emotions.
Learn from Successful Traders
One thing that is true for life and for trading is that learning should never stop. Successful traders can teach us a lot of about trading through their books. On the other hand, access to an online trading community, where you can consult your more experienced peers, have your questions answered and even use copy-trade, can be a great way to learn and grow.
Discussion forums are also great for learning tips and tricks of the trade, quite literally. When you share with other traders, you also get to learn from their mistakes and gain insights into where you might be going wrong.
Although stock CFDs mean that you do not need to own the underlying asset, derivatives trading comes with its own share of risks. Regardless of the tradable asset or means of trading, risk management is a trader’s best friend. Some of the key ways to manage risks while trading stock CFDs are:
Agile & Diversified Portfolio
This essentially means that you not only ensure that you hedge your risks with either other tradable assets or stocks/indices, you are also quick to adapt your portfolio to the changing market conditions. Also, keep track of laggard performers among stocks and revise your portfolio accordingly.
Stop Loss & Take Profit
Set your stop loss and take profit levels before entering into any position. This can help limit losses or lock in profits, when the market moves in an unfavourable direction. These orders also ensure that you do not overtrade or under-trade, due to overconfidence, greed or fear.
Use Leverage Carefully
One of the biggest advantages with trading stock CFDs is that you can benefit from leverage. With leverage, you can gain a much larger exposure to the market than would be possible with only the amount in your trading account. However, while this can help you multiply your profit potential, it can also magnify potential losses. So, determine how much you can afford to lose in a single trade and choose your leverage accordingly.
As well as these fundamental risk strategies, keeping a trading journal to learn from your mistakes is always a good idea to grow as a trader. It helps you identify patterns and emotions, so that you can improve on your trading decisions.
Which stock CFDs are you looking to trade? Tweet us at @Derivdotcom and share your experiences.