Risk management tools are special orders you can place in addition to every trade you open to have better control over your trading capital. Seasoned traders have multiple techniques and strategies to minimise their risk exposure, but the logic behind all risk management tools is the same – stop the losses or secure the gains.

Stop loss

A stop-loss risk management tool can help you stop your losses on a losing trade. For example, you open a buy CFD trade at USD 1,000 and predict the price will go up. In case the price moves against your prediction and goes down instead, you are not willing to lose more than USD 5 of your capital. So, you place a stop-loss order at USD 995, and your trade will be automatically closed if the price reaches that level. It may seem logical to have your stop loss at USD 1,000, not to lose anything at all, but the price never moves in a straight line, and your trade needs some room to pick up momentum.

Take profit

A take-profit order, on the other hand, can help you preserve your profit on a winning trade. Like in our previous example, you go long and enter a trade at USD 1,000. The price does go up, as you predicted. So, you place a take-profit order at USD 1,100, and your trade is automatically closed when the price reaches that level. It may also seem logical to have your trade running to get a higher profit. However, price movements are unpredictable. A trend can reverse anytime, wiping off your profit and turning your successful trade into a losing one.

Take profit

Using stop loss and take profit won't guarantee your gains and won't eliminate your losses . Still, they can help you control your own trading capital.You can also manage your time more effectively because once you place your order, you don't have to actively monitor it. Instead, the broker will close your trade if the price reaches your predetermined levels. Another benefit is that they can reduce emotional stress, as you do not need to monitor your trade like a hawk and experience the up and down price movements. As you know from the onset what your maximum loss will be on a specific trade, it also allows you to discount this from the start.

Similarly to the risk management tools available to you as a trader, a broker you trade with also has a mechanism to secure its funds. An important part of this mechanism is margin.

What is margin in CFD trading?

Margin in trading means a deposit required by a broker for every leveraged trade you place. It helps a broker minimise the risk of lending money to you as a CFD trader. It is an important part of a trading process because if your leveraged trade turns out to be losing, your broker will lose money just like you. From our example in the table above, you can see that if the price moves against your prediction, you can lose USD 100, although your initial capital was only USD 5. So the USD 95 of that loss are the funds you borrowed from a broker.

To help prevent big losses of the funds it lends to you, a broker will block some part of your trading capital every time you open a trade. This amount is called a margin and serves as collateral.

Margin is usually described as a percentage, also called a margin requirement – 0.5%, 10% or 50%, for example. This number indicates how much of a total trade value is required for a deposit.

If you want to open a trade worth USD 1,000 and its margin requirement is 0.5%, you'll have to put down USD 5 as a deposit to open this trade. This amount doesn't get deducted from your account – it is simply blocked for as long as a trade is open. Once you close your trade, this amount is released, and the profit or loss of your trade is added or subtracted from your account. Essentially, the margin amount is blocked in your account to make sure you have enough funds to cover potential losses.

The relationship between margin and leverage

Margin and leverage are two parts of the same concept. A 200:1 leverage means you need to pay only the 200th part of the whole trade amount, and this amount is the margin.

Margin and leverage are also inversely related – the larger your leverage, the smaller your margin. Here is how you calculate a margin requirement of your trade if you know your leverage:

Margin = reversed leverage ratio
Margin = 1:200
0.005 = 1:200
0.5 % = 1:200

When trading with leverage, you will also often see the term margin call. A margin call is an alert issued by a broker to a trader to announce that the funds in their trading account are lower than the margin requirement.

Margin calls are usually issued when the total funds in a trading account are below 100% of a margin requirement. Once it happens, a trader usually has two choices – to deposit more funds to cover for the shortfall inmmargin or to close the trades to free up margin. If neither happens, a broker will liquidate (close) the trade automatically once the amount of funds in a trading account drops to a certain level. The margin call policy varies from broker to broker, but most of them liquidate a trade once the total balance of a trading account is below 50% of the required margin.

Margin call and stop out level

There may also be additional requirements and things to keep in mind when you trade CFDs, but this sums up the basic knowledge of CFD trading. We suggest putting into practice what you've learned so far to grasp it better by using a demo account.

Create a free demo trading account on our award-winning trading platform ThinkTrader and practice trading risk-free with virtual funds.

CFDs Trading Articles

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Risk management tools in CFD trading: stop loss and take profit

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