Trading derivatives

DERIVATIVES TRADING AND CFDS - To Stop Loss or Not To Stop Loss

Perhaps one of the biggest differences between buying physical shares and trading shares through CFD's or similar derivatives trading instruments is that when trading physical shares one normally does not have a stop loss. With geared derivatives like CFDs gains and losses can accumulate very quickly, it makes sense that a stop loss would make for a good safety net for short term traders. However, although it may appear logical in theory, in practice the issue of the stop loss divides the trading community. There are those who believe that trading without a stop loss is like driving a car without brakes and those who hold the opposite view that all their trading woes can be blamed at the markets hitting their stop losses.

Perhaps the reason for the sharply divided views is that different trading techniques require different money management techniques. The controversy arises from the way that in traditional share dealing, of the buy and hold variety there never is a stop loss. While shareholders of such famous names such as Marconi or Railtrack may actually try and forget this point, without a stop loss on an investment you are effectively risking the entire capital involved. Of course, normally one is not pushed to the limit as would have been the case with Marconi or Railtrack, but this can happen and losses can be substantial.

With geared derivatives such the CFD the leverage effect multiplies the effective size of the deal you are in, with only £10,000 of margin required to covered £100,000 or more. Obviously if you have £10,000 in your account and you do not wish to add more funds there should be some way of controlling the risk you are exposed to. In today?s volatile and very fast moving markets it may be that you cannot manually exit a position in time to avoid taking a large financial hit. This is where the stop loss can allow you to live to fight another day rather than have to leave the trading arena. In addition, if you are a technical trader you would find it quite convenient to place a considered stop loss on the basis of previous chart support or resistance or appropriate trend line.

But therein lies the problem with stop losses. In some ways they become a victim of their own success. Too many stop losses at a certain level can mean that the share price of a stock can actually have a tendency to seek out stop losses in quiet markets or illiquid stocks. Also stop losses can suffer from the 'great minds think alike / fools seldom differ' syndrome; traders tend to all place their stop losses at the same level and can see them hit simultaneously.

Why does this happen? The old stock market emotions of fear and greed come into play. A stressed trader will somehow manage to choose levels where she or he is just stopped out, a cool headed one will remain in position. The answer here is to choose stop loss levels before taking a trade and never to adjust them afterwards.

On balance, the power of statistics has to rule the day in terms of whether stop losses are good or bad for your financial health. The best derivatives trading players take regular small losses and the occasional big profit with a sensible stop loss strategy of perhaps 2% of the account risked per trade. The unsuccessful trader takes many small profits and then the occasional big loss and in an attempt to avoid taking small losses actually ends up taking large ones.  In the end proper risk management with strict stop losses placed at the inception of the trade has to be the safest way to mitigate downside.