Regulators in Australia and many longer term investors are very cautious when it comes to trading contracts for difference (CFDs). The reasons for their caution can be warranted given that traders have the opportunity to lose more than what they start with.
The key reason you can lose more than what you start with comes down to the leverage that contracts for difference (CFDs) give you access to. A CFD is almost identical to trading shares, except you need a small amount of money up front called your margin. When trading blue chip stocks like Woolworths you may only require $500 of your money to control $10,000 worth of position.
Given the leverage CFDs give you access to (up to 20 times your starting balance) it is not uncommon for traders or investors to abuse this privilege, especially when greed is involved. You see leverage compounds your returns but unfortunately leverage works against you quickly when you are losing.
It is for this very reason that many CFD brokers have created a stop loss facility that actually guarantee’s you a price to get out, even if the market never traded there.
A Guaranteed stop loss (GSL) is a stop loss that is essentially your insurance against a catastrophic loss or large gap in the stock price of the company you are trading. When volatility increases like it did at the start of 2008 you will find stocks gapping constantly as they react from news on the London or US stock market. Given we are a resource heavy stock market, our stocks can also react heavily to news coming from the futures market like Gold, Crude oil or Copper rising or falling significantly.
When the US stock market drops over 350 points (nearly 3%) like it did on the 26th of July 2008, you can expect our market is going to gap down significantly on open. A gap in price is simply the difference between yesterday’s close and today’s open as illustrated in the following candlestick chart.
Essentially the market is a balance between buyers and sellers, demand and supply. A gap down is a result of more sellers or more supply hitting the market and a gap up is a result of increase demand or more buyers flooding in.
Sometimes the gap in price is quite small, say a couple of cents on a $10 stock but sometimes the gap might be considerably like 5% or more. Now couple this with being on the wrong side of the market and using leverage. It doesn’t take Einstein to work out there is going to be some severe losses to your trading account.
Many CFD providers in Australia allow you to place a guaranteed stop, thereby protecting your worst case scenario or worst case loss. Consider a guaranteed stop loss like taking out insurance on your house. You buy insurance on your house to protect against fire or theft and the goal is not to exercise that option which means the house never got burgled and didn't burn down.
Each year we pay our premiums for that protection. Consider Guaranteed stop losses the same way. The goal is that our stocks do not gap down excessively but if they do we can purchase that protection.
Current Stock price: $10.00
Number of shares you own: 1,000
Position size: $10,000
Guaranteed stop placed at: $9.50 or 5% away
Price for guaranteed stop: 0.3% * $10,000 position or $30
Market gaps down when bad news about this stock hits the market.
Market opens, stock price hits $8.75.
All traders can get out at first available price.
Your guaranteed stop gets you out at $9.50.
Your saving: ($9.50 – $8.75) * 1,000 = $750
Cost of insurance: $30
Note: If the stock didn't gap down then you would be out of pocket $30.
Many full time traders have a goal of keeping trading costs low and as a result guaranteed stop losses don't really have a place in their portfolio. Considering the risk tolerance of all traders is different it really comes down to you appetite for risk or more importantly your desire to eliminate a worst case scenario.
Recently CMC Markets launched a product directed at Self management super funds (after a recent tax ruling by the ATO) called the Shield account which allows traders and investors to have absolute downside protection. Traders put up more margin on a smaller product set and every single stop is a guaranteed stop loss with brokerage set at 0.25%. The main feature of this product is not being able to lose more than what you start with. If you put in $5,000 and wipe the account out then the most you can lose is your starting balance.
Whilst the concept behind CMC Markets Shield account is sound, it will never replace the fact that to become a successful trader requires a proper trading foundation with sensible risk management rules.
Guaranteed stops or not, successful trading requires you to trade intelligently.
Learn CFDs.com is dedicated to helping traders of all levels discover simple and effective trading strategies. We primarily focus on developing a solid trading foundation that sets the platform for long term trading success.