CFD 101: An introduction to CFD Trading Systems

Usually CFD traders depend on a trading system for all their trades. There are different types of systems available of which some are completely mechanical and can be customized and backtested. Also it is to be mentioned that not all systems are equally efficient.

You can choose a profitable trading system with less drawdown by backtesting a number of systems. There are some other trading systems available that are part discretionary. However, this does not necessarily means there is no systematic approach available. Despite these systems not being fully mechanical, there is still a step by step systematic approach that has been proven to be profitable. These systems can be learnt from some other trader who has already traded the system effectively. A trading system will help you to make profit consistently and monitor your trading performance and usually helps to keep emotions out of the business.

Basic Functions of a CFD Trading System

Definition of CFD trading system: A trading system is a set of rules that determines how you will execute each and every trade in the market. In case of a mechanical system, you can write down the whole trading plan and some other trader can follow your developed system as well. This is very much possible because the system is entirely mechanical and a CFD will either pass or reject the rules, the ones that you have developed. You can efficiently program your very own trading system with the help of trading software like WealthLab, Metastock & TradeSim or TradeStation. After developing the system, you can backtest it against historical data (say the data of the last 10 years CFD trading) to see how it performs. And after testing multiple systems, you can choose the most profitable one which doesn’t come up with a significant level of drawdown. The whole concept is very much interesting and attractive considering the fact that with the help of the right resource, simply anyone can develop his/her own system and backtest it to figure out its effectivity.

Any CFD trading system executes three important things:

1. Cut down the loss: This means, when a trade goes against you, you exit the position with a smaller loss. Reducing loss in your trading is done by using a stop loss, which is in contrast to some traders who intends to put their funds into the stock exchange or CFD and does not intend to exit, seeing their losses getting bigger and bigger until they finally lose a considerable amount of float. The stop losses of a trading system should be fixed at a point which will make sure that it is not pushing you out of the market due to minor movements of the CFD price or not should not be placed at a level where your losing trades become too large comparing with your winning trades. So the stop loss should be fixed at a medium level.
2. Increases profitability: A trading system allows the CFD to run with a spacious trailing stop so that you can generate more profits from a trade that goes in your direction. However, the trailing stop should be close enough as well to make sure that you can exit the positions when the trade goes against you. A profitable trading system that allows the profit to run ensures that your profit will grow bigger than loss. However, this doesn’t happen that frequently.
3. Maintaining an acceptable profit-loss ratio: Profit loss ratio refers to the size of the average profit in comparison with the size of loss. For instance, with an average profit of $1000 and average loss of $200, you will have a profit loss ratio of 1000/200 = 5.

   There is another term called win-loss ratio that refers to how many wins a trader gained in comparison to his losses. A trading system can still proven to be profitable with a modest win-loss ratio if the profit-loss ratio remains at a good position. By multiplying the win-loss ratio with profit-loss ratio, you get profitability ratio. As long as it is higher than 1, you can consider the system as a profitable one. For example, for the last case, beside the profit-loss ratio of 5, if a trader has 40% wins and 60% loss in his trades, his win-loss ratio would be 0.66. So his profitability ratio is going to be, 5 x 0.66 = 3.3. This is the basic principle that determines whether a system is profitable or not. However, you need to keep this in mind that having positive results from backtesting doesn’t guarantee similar result for future.

Elements and factors that a mechanical CFD trading system should specify:

1. Instruments that you are trading: A CFD trading system specifies what instruments you are trading. For instance, you may be trading Australian, US or UK CFDs.
2. Entry conditions: A CFD system also specifies the conditions or what has to happen for you to enter a CFD. For instance, price action or indicators can be used by the systems to signal that a CFD is trending in a certain course, maximising the profitability for the trade.
3. Exit conditions for a trader: Along with the entry conditions, the system also specifies that what has to happen for a trader to exit a trade. For instance, a trader can use a stop and a trailing stop. Let’s assume that he has entered a long trade at $5.50 with an initial stop at $5.30. So, if the trade goes against the trader, he will be exited from the position at $5.30. This helps the trader to reduce losses. In this particular illustration, the loss is 20c per CFD entered plus costs and broker’s commission.

   The stop that moves as the trade goes in the direction of your trade (up for long trades) and exits you from positions when the trade eventually turns against the direction of the trade is called trailing stop. This is something allows the profit to run and preserves it as well.

4. CFD Risk management rules: In the risk management rules, the CFD system specify how much of your total floats you are going to place in each and ever trade. Money management is considered as a vital factor in CFD trading due to the fact that having no money management rules and putting too much funds proportionally in each trade can lead you to losing your account from smaller losses. In CFD trading, not all trades are going to provide you the same result. Some are going to be winning while some will be losing trades. A good money management plays a very important role at this point by ensuring that the losing trades won’t cause a massive damage to your account and on the other hand will allow your system to continue trading and making profits. The equity curve surely mover upwards with a profitable system, but that is not going to be a straight line for sure.

   While backtesting your system, in order to find out the effects on historical profits and losses, you will have to test your system with a money management model. You will have to select the right risk model that will best suit your system. It is important that you look for your own financial advice before entering the market for trading.