While they are often described as simple investments that are easy to trade, there is a lot more to CFDs – contracts for difference – than meets the eye.

That?s because as an alternative way of trading a host of different investments, they come with not only the potential rewards but also the risks associated with the individual investments ? which could be shares or a share index, gold, oil or a foreign currency.

There are also the rewards and risks associated with trading CFDs themselves which the basics of CFD trading explain. Last but definitely not least are the rewards and risks of being a trader.

With CFD over shares, for instance, while the ideal scenario is companies growing their businesses, managing their debt levels and meeting their profit forecasts there are also such risks as companies reporting skeletons in their closet that they haven?t previously disclosed.

Or it could be companies or the broader market being swept along by a phenomenon such as the global financial crisis which can affect not only shares but other potential CFD tradeable investments as well.
 
As far as CFDs are concerned it is therefore very important to understand what you are trading.

At the same time you must also understand the power of the CFD product which boils down to appreciating the risk you are taking with each trade, with risk in this instance meaning the chances of losing money.


Starting with a plan

Capital and money management
To trade CFDs there are three very important fundamentals. One is to have some capital that you can trade. As a general rule this should be money you can afford to speculate with. In other words, if you lost this it would not be a disaster for you.

Associated with your capital is a money management plan which is basically a system you use that will make your trading capital last. Money management is a vital discipline for all traders who wish to give themselves the best chance of success in CFD trading.

What money management does is identify the amount of your account balance you are prepared to risk with each trade. One suggested strategy is to risk no more than 10 per cent of your account balance on any one trade.

If you follow a 10 per cent rule, this might involve dividing your money into 10 equal portions or spending no more than 10 per cent of the ongoing balance of your account on each trade.

A widely suggested strategy is the 2 per cent rule where you risk either 2 or 2.5 per cent of your account balance on each trade. Another very commonly quoted strategy is being prepared to risk risking.  

What money management does is allow you to deal with a losing streak.

It deals with one of the realities of trading that there is no perfect trading system. This means that no matter how good your system is, you will experience difficult times.

There are numerous ways of implement a money management strategy.  Some are very simple and some are rocket science.  But even the simplest method will put you ahead of anyone who does nothing at all.

Money management in practice
One challenge for many new traders in CFDs is deciding how much money to commit to each trade. Many use a gut feel method of either round dollar amounts or acquiring a round number of CFD positions. Such decisions can be fairly random.

Where a money management strategy can help in this regard is combining risk management with position sizing.

One way to illustrate this is through an example. Say you have a $20,000 account balance and a money management strategy where you will try to risk no more than 2 per cent of this on any one trade. In dollar terms that is $400 per trade.

To calculate a position size you will first need to consider the investment your trading strategy has identified. Say it is BHP shares trading at $38. While you take a long CFD position because you expect the price will keep rising, you also want to protect your capital from any adverse move.

In many instances, traders will use charts to help select a level where they will sell the shares if they fall in value and therefore go against your view. The idea is to avoid any further loss. Such levels are described as stop loss points.

What charts can show is recent low prices from where the shares may have rallied and where they may have some support if they retreat again.

Say this happens to be around $36.40 which means that if the price does fall from $38 to this level and you sell you will lose $1.60 on each CFD position. This is a decline of just over 4 per cent.

If you apply this $1.60 risk amount to your willingness to accept a loss of $400 per trade, this suggests you will acquire about 250 BHP CFDs ($400 divided by $1.60 = 250).

So your money management strategy will then determine the dollar exposure you have to CFDs over BHP shares: 250 time $38 = $9500. Using a 10 per cent initial margin deposit requirement, you will create a position with a $950 margin deposit where your downside will be $400.