Stop losses are indispensable to limit CFD trading risks

Philip Salter
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UNLESS you have the risk appetite of the American daredevil Evel Knievel, you would be foolish not to use stop losses on your CFD trades. In volatile market conditions you ought to go one step further and set guaranteed stop losses. It is also important not to set stop losses too tight, while it makes sense to use trailing stops to lock in your profits in a rising market.

A stop loss is “simply an instruction to close a position if the market has moved against you,” explains Angus Campbell of London Capital Group. Using them is critical for managing risk because small moves can lead to big losses. Also, you don’t have to sit all day watching a screen, says David Jones of IG Markets.

Guaranteed stop losses ensure that even if a market plummets, or opens up below your stop loss, the CFD provider takes the hit instead of the trader. There is a premium of a few points for this guarantee, but under certain circumstances this precaution comes highly recommended. Jones suggests guaranteed stop losses are particularly useful when trading equities around results time. Michael Hewson of CMC Markets agrees that guaranteed stop losses can be useful, using the example of Northern Rock’s 31 per cent tumble in September 2007. CFD traders long on the Rock would have got seriously burnt without a guaranteed stop loss – a stop loss was not enough as the market opened so far down.

Jones argues that the most common mistake made by CFD traders is that they place their stop losses too tight. On a typical trading day, a tight stop loss can be picked off by market volatility. However, there is no golden rule of where to set stop losses. To demonstrate this, Jones points to ARM Holdings, which is often volatile to the tune of 6 per cent, while 3 per cent would be a significant move for Vodafone. But in setting stop losses, Jones advises that traders don’t pluck levels out of the air. Instead, he suggests taking a look at the charts: so when shorting set stop losses at resistance levels, while when going long set stop losses at support levels. As such, Jones recommends that for “a buyer of FTSE 100 last week a stop beyond 5,500 looked like a logical place”. This is because in “September and late November the FTSE pulled back towards 5,500 and bounced” (see graph, left). Hewson adds that traders should not set stop losses too close to past lows and highs to avoid being taken out by overspill.

Simon Brown of ProSpreads says “people spend too much time thinking about how to enter a trade and far too little time on how to exit a trade.” As well as setting and sticking with your stop loss, traders should also set profit targets. Brown says predefined stop losses and profit targets help take the emotion out of trading – taking profits too early is a mistake as common as setting up the wrong stop losses. Here, trailing stops can be useful. Trailing stops step up with a rising market, locking in profit.

If you don’t want to spend your waking life plugged into the charts, then sleeping on tenterhooks at night, you should set stop losses for your CFD trades. You should consider setting up guaranteed stops, especially if an announcement is going to be made that could see things change when the market is closed. However, don’t overcompensate and set your stop losses too tight. You don’t want to crash out if the market goes on a random walk.