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Whether you’re beginning your forex journey with CFD trading or a veteran in the game, understanding what a stop loss order is and how it can affect your trading should be priority number one.
CFD trading as a whole comes with numerous benefits making it enticing for a new trader, but it’s inherently risky due to leveraged accounts, weak industry regulation and other risks.
Keep reading to learn more about what CFD trading is, how it works and why you should use a stop loss order.
CFD is an acronym that stands for contract for difference. It’s a contract between a buyer and a seller that states that the buyer must pay the seller the difference between the current value of a commodity or asset and the value it holds during the contract.
CFD trading is an enticing way to trade for retail investors and for an investor account because it allows for an opportunity to profit from the underlying asset price movement without actually owning the asset itself.
A CFD or contract for difference is an agreement between the retail trader or investor and the broker to exchange the difference between the current value of the asset and the value between the time the contract opens and closes.
Because there’s no actual delivery of the assets or securities, the investor never actually owns or touches the underlying asset. For example, instead of purchasing physical gold and selling the gold, the investor speculates on gold’s price movement instead.
Effectively CFD trading involves traders and investors betting on whether the price of an underlying currency will rise or fall. If a trader bets that a CFD’s asset will increase, they will purchase a CFD and net the difference between the purchase price and the sale price. The settled amount is the net difference that represents the gains from the trade.
Oftentimes traders will confuse CFD trading with spread betting. However, the main difference between the two is that spread bets have a fixed expiration date and are conducted over the counter, while CFD trades have no expiration date and are traded within the direct market.
Although CFD trading sounds like the route most traders would want to go, you must be aware of the risks. These include weak industry regulation, margin maintenance, the trader paying the spread, and liquidity risks, to name a few.
All CFD brokers will have the basic order types, but some may have names that are unfamiliar to those just starting their trading journey. As a whole, all trades will either be a market order or a pending order.
A market order is an instantly executed order placed at current market buy and sell prices provided by your broker. On the other hand, a pending order is an order that’s placed to be executed at a later time and at a specific price point.
In other words, a market order is an instant buying or selling order at the best available price. Keep in mind that depending on market volatility, there may be a difference between the price you think you placed an order at and the price that it finally fills. The final price will depend on the financial instrument, your broker and your trading platform.
There are four types of pending orders to be aware of:
A buy limit or sell limit order is an order that you place to buy below the market or an order to sell above the market at a price you specify. Essentially, it’s an order to buy or sell once price movement reaches the limit price you specified to trigger the order.
So remember, a buy limit is an order you place at or below a specific price when you expect the price to go up and a sell limit is an order you place to sell at a specific price or better when you expect the market to move down.
It’s important to remember that when you place a limit order, the order will trigger at the current market price after it hits the specified price. In other words, a buy limit will fill at the current market price equal to or less than the specified price and a sell limit will execute at a price equal to or more than the price you specified. Either way, you get your price or better.
Like limit orders, a stop order is an order to execute a trade once it reaches a specific price. In this case, a stop order prevents an order from executing until it reaches a stop price.
You will initiate a buy stop if you want to execute a trade after it rises past a certain point and a sell stop to sell after the price falls past a specific price.
In other words, a buy stop is placed above the current market price and executes when the market price reaches or rises past the buy stop price and a sell stop, or stop loss order, is an order to sell when you reach a specific price.
A stop order or a stop loss is generally only executed when the price becomes less favorable to your trade idea. For example, assume you’re long GBP/USD, and the trade is going in your favor. You would place a sell-stop order to protect your profits.
Similarly, it’s always smart to use a stop loss when you place any trade to not lose your money and to get in the habit of minimizing your loss period. This is especially important and a useful tool if your positions are traded on margin, and you need to stay within margin requirements.
Another type of stop loss order is a trailing stop. This is a stop loss order that can be attached to any open long or short position. It’s set to automatically move at a specified rate once the price moves equal to or higher than a specific price level.
This is an extremely helpful tool to have if you don’t want to spend every waking moment in front of your computer. However, it’s important to note that while the price will move as the trade goes in your favor, it won’t move in the opposite direction.
For example, assume you’re short GBP/USD with a 50 pip trailing stop. That means the trailing stop will move 50 pips down every time the price moves 50 pips down and stay at the new level until the price moves another 50 pips down. If the price moves down 40 pips and moves back up, then it will trigger the trailing stop and close the trade.
CFDs are complex instruments, and it’s always beneficial to use a stop loss when CFD trading. However, you must remember that a stop order acts as a threshold for your order to execute. That means you won’t know the exact price that your order executes, and it may be worse than expected, depending on market conditions.
On the other hand, a limit price acts as a sort of price guarantee that gives your order filled at your specified limit price or better. However, the catch is that the price may never reach your specified limit price. So if you want a guaranteed fill without a guaranteed price, you’ll want to use a market order.
There’s certainly a tradeoff when deciding if you want a stop or limit order for your CFD trading. However, using a stop loss is a sure way to build a good habit of minimizing losses by not letting losers run and keeping your trading account open to participate another day.
A stop loss order is a tool used by both retail investors and institutions and a basic order that you must fully understand to stay in the game long enough to be consistently profitable.
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