Risks and the necessity for stop losses

What are they:
Contracts for Difference (CFD) is simply a synthetic equity product traded on margin. By trading a CFD with another party, the trader transacts does not in shares per se but in share price movements over a fixed period. The return is generated by the difference between the opening and closing prices of a specific share.

Risk:
CFDs are promoted as an ideal short-term trading tool. However there are risks. Potential traders need fully to appreciate the risks and costs involved. Because profits and losses are based on the full transaction value they can be significantly larger than the initial margin required to establish the trade. For example a trader going long $100,000 of a share that has a collateral base of ten percent (10 times leverage) will only be required to place an initial margin of $10,000. A move of 10% in the share price will mean a 100% return or loss on the initial capital.

Stop Loss Vs Guaranteed Stop Loss (GSL)
A stop loss order allows the trader to set a price which if reached will automatically trigger a sell order (for long positions) or buy order (for short positions) to close their current position. With a simple stop loss if the share or index breaches the set stop loss then the order will be executed at the next available price at the time of dealing. This may mean the order is executed at less than the stop loss price in the case of a long position or more than the stop loss price in the case of a short position.
However, the use of a guaranteed stop loss overcomes this. As it suggests this is a stop loss order that is guaranteed to be executed at the price the trader specifies, even if the price of the underlying share or index makes a sudden movement and never actually trades at the price that specified, the position will still be closed at the chosen price. This may not be the case with a simple stop loss.

A recent Irish example:
�The so-called luck of the Irish ran out last week for a group of CFD traders on the Emerald Isle. At least �50 million was lost in minutes during lunchtime last Monday by private clients of Irish stockbroking investors in pharmaceutical company Elan. The traders had staked money on CFDs, which are not regulated by the Irish Financial Services Regulatory Authority (IFSRA), so their losses were amplified when Elan�s share price collapsed by 70% last week. Elan was among the most-traded shares using CFDs in Ireland. Last Monday�s debacle, when Elan announced it was suspending its multiple sclerosis drug Tysabri, has raised questions as to whether CFDs should have been promoted for use in an underlying share as risky as Elan. Some senior broking sources have confirmed that Irish private investors had staked at least �15 million on CFDs based on the Elan share price rising ahead of Monday�s crash. The leverage of CFDs, therefore, means those investors are facing losses of at least �50 million, given the 70% share price collapse. It is actually the second time in just over a year that CFDs have been responsible for amplifying the losses in an Irish share price slide. Investors trading CFDs raised regulatory concerns in January last year when Ryanair shares fell following the airline�s profit warning.�

Risk Profile:
Every traders risk profile is different as is every stocks risk profile. As the Irish examples testifies to, the more speculative the stock, the higher the inherent risk associated. As such, those CFD traders with a more aggressive risk profile trading these more risk-prone shares suggests a GSL is mandatory.

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