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CFDs: probability and price action in trading

Contracts for difference, or CFDs, allow traders to profit from short-term moves in an underlying asset. However leverage comes with increased risk and it is how a trader deals with this risk that is so important. Understanding probability and price action are two important factors.

All trading involves risk. Losses can exceed deposits.

CFDs are a leveraged product. They allow traders to speculate on where a market could be headed while placing a fraction of the face value of the position that you would do in the equity, FX or futures markets for example.

Leverage opens up a realm of possibilities, however it comes with increased risk and it is how a trader deals with this risk that is so important. Therefore, a trader is first and foremost a manager of risk and if you are not protecting the capital in your account and acting on higher probability set-ups then the likelihood of failing as a trader increases.

Increasing probability of success through order execution

Following the money flow is key if one’s time period is short-term, which is really the timeframe suited for trading CFDs. In my opinion it makes little sense to buy a market where the price is in free-fall, unless you have a well-tested mean reversion strategy. Unless you see price action displaying signs of reversal (study candlestick analysis), buying a falling market is already a low probability set-up and the odds of a losing trade are elevated. Hitching a ride and buying an asset that is going up increases the odds of a profitable trade. Of course, many will focus on achieving the best entry level within the trend by looking at a range of technical indicators, but that is for another article.

Trading and investing are different

Investing is really about finding a ‘fair value’ when one has discounted the expected cash flows of future earnings. But a stock investor also needs to understand a company’s strategy for growth and believe that management has the ability to find and deliver shareholder value. When investing the adage ‘buy low and sell high’ holds true. However, in the CFD market I would say buying high and selling higher, or selling (‘short’) low and buying back lower makes far more sense in the majority of cases. Again, follow the trend, follow the money flow and increase the odds of a profitable trade.

Event risk

Understanding upcoming event risk can also aid probability. Take a regular look at the economic calendar and assess what the big economic, political or organisational events (OPEC for example) are and make a judgement call on whether you feel these events could directly or indirectly affect your position. It could be wise to reduce your position, or even trail your stop closer to the market around an announcement if you think there could be a sizeable move as a result of the event. Trying to forecast or predict the outcome of events can be almost impossible (take the UK referendum for example) and so often even the best market gurus get their estimates or predictions horribly wrong. Again, this feeds into the importance of protecting the portfolio, which plays a role in increasing the probability of staying in the game.

Above all understand supply and demand – price action

Having an understanding of price action is so important when trading short-term. Making decisions purely from fundamentals in asset classes such as foreign exchange, commodities or global indices can be extremely difficult, because you simply have to take into account so many variables. Price will rationalise and aggregate all of these inputs and acts as a roadmap of supply and demand and will tell you what the market is thinking and importantly whether the bulls or the bears have control of a move.

Understanding price action can again really help assess the sentiment in a market and again this can help with the probability of success in trading.

Take US light crude for example. On any week we have to consider the oil and gasoline inventory reports and very few have genuine insight into the changes in inventory levels at Cushing, Oklahoma and many of the other big oil US storage plants. We have to look at the weekly US Baker Hughes Inc oil rig count to understand if US shale gas companies are bringing supply back online with the oil price moving into the profitable, or breakeven zone. We also have to consider the likely direction of the US dollar and what OPEC and non-OPEC nations are doing with future production. Price aggregates all known information and tells you explicitly what all the market players are thinking at any one time.

Risk management

In trading once we know the asset we want to trade there are really three main considerations. Our entry point, exit point and position size. We have absolutely no control where the market will go, so it’s how we deal with the ever changing conditions which defines our profitability as a trader.  

Being able to define and manage one’s risk is absolutely fundamental in short-term trading and again plays such a strong role in the probability of survival. A stop loss is effectively a commitment to say ‘this is where my analysis is wrong and I’m happy to cut and run’. Where that stop level is placed will be dictated by a number of factors, but to be able to admit you are wrong and move onto the next idea is key. Remember professional traders suffer taking small gains, retail traders suffer taking large losses. Don’t get into a situation where you have to take a large loss — get out of the position at a point where you feel you have been proven wrong. The best traders are in effect the best losers.

Once we understand what we are risking we can then focus on where to target to achieve a compelling risk-to-reward. The adage of staying long (or short) until proven wrong is very true here, but it can be the hardest thing in trading to keep a profitable position open when your gut instinct tells you price is about to roll over and head lower.

We don’t actually need to have a winning trade every time, but if you have a strategy that is more often wrong then one has to adjust the risk to reward. One can even get a third of their trades in the money, but they have to make twice what they were risking. Of course all new traders think about the win rate, but that is not always correct.

Next time you trade think about the probability of the outcome. 

Win rate Risk Reward
98% 50 1
91% 10 1
83% 5 1
75% 3 1
67% 2 1
50% 1 1
33% 1 2
25% 1 3
17% 1 5
9% 1 10
2% 1 50


This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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