I recently gave a presentation on the basics of contracts for difference (CFDs) and, in particular, managing risk. CFDs are a trading instrument and are not for use by investors. But everybody knows about having a stop-loss order — which gets you out of a trading position if it goes against you.
A stop loss is non-negotiable. Every trader, even a new one, knows its importance in limiting investor losses. That said, obeying a stop loss may be hard, but these days most trading platforms will let you place one at the time of entering the position, ensuring you have it in place from the get-go.
There are other risks inherent in trading that many ignore or aren’t fully aware of. These still matter.
A key risk is as simple as what you choose to trade. Typically, new traders will start with either shares or FX. The latter is popular because of the insane gearing offered by FX platforms. This gearing is certain to lead to a new trader losing all their capital and potentially more than they started with …
Shares are attractive to traders because they are well known. Investors feel they have an edge in “knowing” the businesses, as they often know the brands and, in some cases, use or shop these brands. There is also a wide range to trade, which creates the illusion that the trader is in charge and will pick the best opportunity.
The problem is that just because an investor shops at Woolies does not make them an expert in any way of the short-term direction of the share. Nor does more choice make us better at choosing. Rather, it probably makes us worse.
The real problem with share trading is volatility. My Opus 5.5 AI crunched five years of daily price moves on the current 42 shares making up the local large cap Top 40 index. On average, a Top 40 share would move 2% in a day, 65 times a year (out of approximately 250 trading days). A 3% move was seen on about 33 days, while 5% moves occurred on an average of 10 days.
This matters because while we look at these large moves and think, “Yay profits!”, we’re missing half the point. What if the move was against us? What if we were just above a stop loss and the share opened 3% lower, slicing straight through our stop loss?
Overnight gaps of +3% also happened around 10 times a year. Again, potentially missing your stop by a mile.
To be fair, some sectors (for example, precious metals) are a lot more volatile. But the reality is that the increased volatility we see in shares adds markedly to risk.
So, the answer is simple. Trade indices. The Top 40 moved +2% in a day only 19 times in the past five years. The S&P 500 moved +2% in a day 15 times and the Nasdaq 37 times. In other words, much lower volatility and, as such, much lower risk and yet still plenty of potential for profit.
This is why I only trade indices. With the more volatile Nasdaq, I reduce position size to manage the higher risk.
