Trading financial instruments is an event with a binary outcome; the price of an asset can only ever rise or fall – if you buy you make a profit and if you sell you make a loss. Given that stock prices have no preference between rising and falling. One should logically expect a near-equal win-to-loss ratio among traders, even if they all trade randomly without analysing the markets. However, when looking at the actual numbers, we see that close to 90% of people lose money trading CFDs. Let’s look at some reasons why this may be.
Spread
Spread is the most obvious starting point to examine for why losing traders outnumber winning traders.
Is also necessary for brokers to make their revenue. Think of spread as starting a race with a few metres of default handicap. To win, you’ll always have to make up ground. In practice, this means that all trades open at a lower value price than their buy quote. A higher value price than their sell quote. Put another way, if you were to open and immediately close a trade, you would make a loss.
Therefore, if traders have just as many winning trades as losing trades they will not break even. This is important to understand. Within the percentage of winning vs losing traders, there is also a deadweight loss that goes to the broker. To overcome spread, traders require a more sophisticated approach than just coin-flipping.
If spread were the only factor influencing the winner-to-loser ratio, then we could expect the difference to be in the same ballpark as the average spread. However, the spread on major currency pairs averages no more than 2 pips – in other words, 0.2%. This alone clearly cannot account for 90% of losing CFD traders. Of course, major currency pairs have the lowest spreads. But the spread on minors and exotic pairs does not increase two hundredfold. Also not to mention those assets are traded far less frequently. Therefore, there must be more to the story than spread alone.
Commissions
Commissions are similar to spread in that they too take a portion off the top of all trades. Brokers usually determine the commission level depending on the asset. It may look something like $10/lot for example.
Some brokers prefer to apply commissions instead of spread, whilst others use spread instead of commission, and many brokers have both. What commissions have in common with spread is that they account for a small loss relative to the trade’s value. In other words, commissions, even when coupled with spread, will still not account for why 90% of people lose money trading CFDs.
Over-leveraging
Leverage allows traders to open larger positions without needing the full amount of capital. This increases the potential trade volume, meaning traders can invest less to achieve similar returns or invest the same to gain more. However, the potential for higher gains comes with the risk of larger losses. Increased lot sizes lead to greater equity swings, which can catch novice traders off guard.
Misuse of leverage is hard to quantify numerically. There is nothing wrong with taking advantage of high leverage to diversify one’s portfolio whilst maintaining a healthy margin level. However, too often, novice traders misapply leverage by opening only a handful of positions too large relative to their balance which, if gone wrong, will wipe their accounts. Many beginners are overly focused on the joy of minimising margin requirements rather than keeping perspective on the full value of their trades, leading to unexpected losses, especially since the effect of leverage is also transferred to spreads.
Leverage Misuse: A Common Rookie Trader Mistake
Underestimating the effect of leverage on spread is probably the prime rookie trader mistake. A new trader may see that they have enough margin to open a position using leverage, however, they will completely dismiss the initial loss that all positions open with due to spread. In other words, before opening a position, a trader must not only ensure they have enough margin but must also be aware of how much free margin will be eaten up by the spread.
This is especially prominent with volatile, high-spread instruments, or even with ‘normal’ instruments close to market open and close times when spreads widen. It is not uncommon for a trade to be stopped-out within a second of opening due to the loss to spread being larger than the free margin.
In short, leverage misuse due to inexperience accounts for why many beginners lose money trading CFDs.
Uninformed trading
When all is said and done, making informed trading decisions will set the best traders apart. One can find the best broker with the tightest spreads, and lowest commissions and learn how to avoid the pitfalls of over-leveraging. Yet without knowing how to interpret and predict market dynamics, trading will remain a guessing game, albeit a more educated guessing game.
Not making rookie mistakes is one thing. But to profit long term, education and knowledge will always remain the key to successful trading. Most people lose money trading CFDs because learning takes commitment and discipline that only those most dedicated will possess. A knowledgeable trader trading under unfavourable trading conditions is still more likely to outperform a random trader, even if the latter trades under the best brokerage.
So, a lack of trading knowledge will always be the biggest factor in why so many people lose money with CFDs.
Giving up at the first hurdle
A person who has decided to try trading for the first time is prone to mistakes. Recalling the previous scenario of novices who incur immediate stop-outs due to spread miscalculations, these traders may quickly conclude that trading is a scam, without ever fully understanding the mistake, and give up altogether. They will never give themselves the chance to transform themselves from an unprofitable trader into a profitable trader, thus maintaining the 90% losing pool.
Conclusion
Trading online comes at a cost and this cost must be overcome more often than not if one wants to stand a chance of success. This can only be achieved through informed decision-making, skill and awareness. Ultimately, it means that only good traders can profit.
Disklaimer: This material is for general informational and educational purposes only and should not be considered investment advice or an investment recommendation. T4Trade is not responsible for any data provided by third parties referenced or hyperlinked in this communication.
