Contract For Differences (CFD) – Chapter 10: CFD Trading With Stop Losses

The power of leveraging with margin trading greatly enhances the ability of a trader to make money with CFD trading. At the same time, it also multiplied the risk level several times over. As such, it is prudent for an investor to properly manage his risk so as to minimize his losses. One of the risk management tools which a trader in CFD trading can employ includes a stop loss limit. With a stop loss limit, a trader will specify a limit as to the maximum loss that he would take before trading. Thus when the market moves adversely against the trader and cause losses to him, the stop loss limit will take effect and stop the bet automatically once the agreed threshold is reached.

The problem with a stop loss limit is that at times the market will react too fast for this stop loss limit to be executed. To protect, himself against such a scenario, a CFD trader has the option to request a guaranteed stop loss limit to protect his investment.

With a guaranteed stop loss limit, the trader is required to pay a small premium to the CFD broker to ensure that the stop limit is put into effect. The risk of any sudden spike in the price is then borne by the broker instead.

For example:

A CFD trader purchases a CFD on the stock of a pharmaceutical company A. Company A is currently waiting for the Food & Drug Administration (FDA) to give a license for its newly developed “miracle drug”. The trader is aware that if the FDA approves the drug, Company A stock will rise. However, if the FDA does not approve the drug then its stock will go down.

The trader is of the opinion that that the FDA is going to approve the drug but still wishes to protect the amount of money invested in the CFD. Thus he asks for a 10 % guaranteed stop loss limit. After a few weeks, the FDA finally makes its decision and rejects the application of Company A for the drug approval based on safety issues. This news causes the stock price of Company A to plummet by 15%. Fortunately for the CFD trader, he had placed a 10 % guaranteed stop loss limit and his loss is limited to 10% with the additional 5% loss borne by the brokerage firm.