Among the questions often asked by clients when selecting an adviser or a system for CFD trading is what percentage of recommendations they can expect to be winners, and how much should they expect to make each month, year or whatever. These form part of a natural psychological comfort zone, but may be part of the reason why so many people fail as traders.
In any area of speculation, whether it is stockmarket investment, spreadbetting, forex trading or CFDs, if the underlying system has a small edge, it is only the first part of potential success. The key to achieving constant returns lies with a correct approach to the win/loss ratio and not in expecting any particular level of gains, which can distort the underlying methodology. CFD traders have the ability to go long and short at will, and online trading makes it easy to adjust stops and targets at any time.
An example of a good win/loss ratio that fails
Consider this example: a CFD trader selects a system where there is a supposedly proven record of seven out of each ten trades proving to be winners. The idea might be that each trade has a target return of 3%, and if it is achieved the position is closed. If the trade however shows a loss of 3%, the expectation is that it should recover and the position is doubled up, with the hope of returning to parity or even making a 6% gain. Now if market or share movements were a random sequence, it would not make any difference where one entered or exited. The overall returns would over time be neither a gain nor a loss, but costs and the spread on trading would result in a virtual guaranteed loss in due course (the casino approach).
Having a slight edge is not enough
If this system had an edge though, the expectation might be that the 3% target would possibly be hit six out of ten times, thus making it a virtual winning approach. But the problem lies in the fact that although markets and shares do have short term periods when there appears to be random action, they can both trade a range and trend strongly at other times – this is what is known as regular irregularity, which might seem a paradox, but happens all the time in financial markets. Shares often move very quickly in one direction, and this trend can continue for far longer than expected, which creates two problems.
First, taking a 3% profit on a trade may appear to be very satisfactory, but it can often be seen in hindsight that the profit was taken too early, so despite achieving a winning trade there is an element of regret that more was not taken. Second, if the position is showing a loss, then the trade should in the real world be deemed to be incorrect and closed out. But in using such a system as this, by doubling up or averaging the position on losses, all that is achieved is an increase in risk – the trader might be lucky in some situations, but one or two trades out of the ten may cause severe problems. There is also the emotional capital that is tied up in losing trades.
This type of system typically might produce say six 3% winners, two evens (where one position was doubled up and returned to parity) and two 10% losers. Here the overall loss would be 2%, despite the good win/loss ratio, and this is clearly a dangerous way to play the markets, but many traders operate exactly in that way.
Improving the risk/reward
The first point is to set a stop loss on each trade and stick to it. Doubling up simply doubles the risk – that is fine if there is another system signal that reinforces the first trade, but generally that is not the case. The problem that then occurs is that if the stop and targets are quite close in percentage terms, the bouts of short term randomness mean that it can almost be like coin tossing, which with costs is a futile approach.
The key is therefore to ensure the gains are much greater than the losses, so that even if one only achieves four wins out of ten, there may be two big winners in there. If a trader decides that a 3% average loss is acceptable, then what average gain should be sought? This is the $64 question, and the key is to let profits runs as much as possible within a clearly defined trend. The following rules are part of the methodology used at Blue Index for the longs and shorts CFD portfolio, and the long term results have so far proved more than satisfactory.
Some simple rules for a consistent winning approach
1. If searching for stock trades, try to choose high volatility or beta shares – these have a higher chance of being in a trend rather than trading a range or exhibiting random action.
2. The expected initial target should always be at least twice the stop loss. If the average stop loss set is 3%, the CFD trader should look for 6%-plus gains on each trade as a starting point.
3. Try to set individual stops and limits with reference to the underlying action. If a share has moved 10% one day, it is likely to exhibit an intra-day range of much more than 3%, so the stop and target should be widened accordingly. Also support and resistance levels are very useful reference points for setting price targets.
4. If the trade hits the initial target, either close the position if support or resistance around that area is seen to be valid, or move the stop up to protect profits and let the position run.
5. If there is a sudden reversal in share price trend, close the position, whether it is winning or losing. The swings and roundabouts of trading usually mean that these unexpected trend changes even themselves out.
6. Make sure you are never exposed too much in one direction. If for instance the market falls heavily from the open, then it doesn’t matter, as even if there are more longs and shorts in your list of open positions, the huge gains on the shorts should outweigh the stops hit on the longs.
As for target returns, many traders have unrealistic expectations. A system that can offer huge returns inherently has to have a higher risk, but bear in mind this simple fact. Warren Buffett has achieved just over 20% per annum returns on his investment fund, and he did not need to use leverage to become the world’s second wealthiest man.