Risks of CFD trading. All you need to know before trading CFD

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Risks of CFD Trading – All You Need to Know

Updated on: 6 January 2020

Is CFD trading risky or is it everything blown out of proportions?

Risks are the first thing that comes to one’s mind when the words “financial trading” start flashing on their pc’s screen. And it is only natural. After all, we are looking to make money, not lose them, right? We all know trading is risky in general. But does CFD trading falls in the same ballpark?

As you might have expected, there are a series of risks to take into account and they come in many forms, some of which you wouldn’t even expect. Some are linked to the nature of CFD trading as a whole, others are related to your behavior as a trader. Which means you can diminish some risks considerably, by adopting certain risk management strategies, while others will be pretty much impervious to any type of control.

So, yes, CFD trading is risky. But this isn’t the answer you were hoping for. If I know one thing for certain, then that would be the way the mind of a rookie trader functions. And the real questions you wanted to ask me were:

  1. Is CFD trading riskier than other trading options?
  2. If it is, what should I expect?
  3. What can I do to minimize the risks?

This is why I will stop wasting anymore time and I will dive right into it. The answer for the first question is both yes and no. Yes, because some risks could potentially lead to more devastating outcomes and no because some of the risks associated with classic trading methods are completely gone within the CFD market.

I know this doesn’t say much, so let me elaborate by taking on question no. 2.

The main risks of CFD trading

I have used “the main” because there may be more than I can provide you with here. I chose to focus on the most important ones, because those are the ones you are more likely to come across and will generally deliver more devastating effects.

1. The use of the leverage

CFD trading works with the help of the leverage. The leverage is the financial strategy of acquiring high value assets using a certain percentage of your own money (somewhere between 5% and 25%, depending on your choices and your broker’s options) and borrowing the rest from the broker or from a bank.

The leverage is the body and soul of CFD trading, which is why it appears so seductive to most people. The problem with leverage lies in how the mechanism works. In order to acquire a $10,000 asset, you only need to place, for instance, 10% of that asset’s value – $1,000.

What this means is that your position will be worth $10,000, despite you having invested only 10% of that amount. As a result, you will be leveraging a higher position with the help of a lower investment. And all your gains will depend on that higher position you control.

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What this tells you is that you will be able to win a lot more money, with the same investment, by leveraging your trading position with the help of CFDs than you could ever win by resorting to classic trading options.

So, what exactly is the risk? The risk is that your losses will be multiplied by the same factor. Which means you might end up losing more than you have in your account. A lot more. Now you know.

2. Over-leveraging

Since you know how leverage works, you most likely understand how over-leveraging works as a concept too. We are talking about situations where inexperienced traders (aka you) go all-in and leverage the hell out of a given CFD position.

This is not a bad strategy in and of itself. It can actually be incredibly rewarding when you hit the jackpot and spot the perfect opportunity to do it. The problem is that the “perfect opportunity” may have different meanings, depending on who analyzes it.

For a beginner, the perfect opportunity could refer to a volatile situation that only gives the impression of stability. And if you resort to over-leveraging in a case like that, the amount of money you can potentially lose cannot be described in human words.

Because you have the leveraging system pumping the loss like an adrenaline shot.

3. The market’s volatility

This volatility could work both for you and against you. But we are more interested in the second part. If the market is volatile, it means you will have harder times to appreciate the real dangers. As a beginner, you will most likely ignore any CFD trading risks and go for the kill anyway.

Then the market swings the other way and take your head clean off. This is why it is crucial to avoid volatile markets or assets, especially if you don’t master the trading techniques of a genuine pro.

4. Becoming overconfident

This is only indirectly related to the risks of trading CFDs. The actual culprit here is overconfidence. Getting several hits in a row could make you feel invincible or give you the impression you are on a lucky spree and make you up the game.

Obviously, that is the opposite of what you should do. Because, in the CFD business, one mistake is enough to cancel all your wins up to that point and take you down from your pedestal faster than it took you to climb it.

Overconfidence is a real threat and I have seen it ruining people in the blink of an eye.

5. Going in the wrong direction

Here is the deal. A lot can happen in the trading business. As a beginner, your job is to make sure you have as many safety nets as possible. And by safety nets I mean information, because that is all that this industry is about.

This means you should never enter markets you don’t know and deal with assets you are not familiarized with. It is not worth the risk of not knowing how the said market will behave or what factors could destabilize the asset’s value.

Always know what you’re getting yourself into.

6. Not using the cut-losses options

I can’t stress enough the importance of this piece of advice here. You need to put stop-losses mechanisms in place to manage your margin account. It is imperative. Stop-losses will prevent you from being financially ruined overnight.

In general, different brokers will have different cut-losses options, most of which have a preventive nature, in the sense that they generally take effect before any loss actually occurring.

7. The hidden danger of holding costs

Depending on your broker, the holding costs may differ in value, as well as in the way they function. But, as a general rule, if you maintain a trading position for too long, holding costs will start pilling up and, next thing you know, you have to use any profits you may have got to cover those costs.

Which means you need to know when to leave your position, especially if it’s not doing that great. Last thing you need is more money to pay, when you already aren’t doing any.

8. Account close-out

This is always a danger if you are trading CFDs. The CFD markets are volatile in nature and things might not go your way all the time. This brings us to the fact that your broker might decide to suddenly close your position automatically, if you fail to maintain yourself above the margin requirement.

This is a measure put in place to protect both you and your broker’s assets, since you are working with a leverage, therefore using his money to keep your position afloat.

How risky is CFD trading you ask? As you can see, extremely. Not in the sense that it makes it absolutely unfeasible as a trading option, but enough to tickle your self-preservation senses. Now, for the most important aspect of them all – can you minimize the CFD risks?

Yes, you can and here is how.

The most important CFD risk management strategies

To be completely honest with you, I could accept you skipping the first part of the article, as long as you get to read this one. You could completely ignore everything I have said so far, if you just follow the next steps with a religious commitment.

We are talking about the most effective risk management strategies you can adopt to increase the safety and the efficiency of your CFD trading. And these are as follows:

1. Choose your broker carefully

Having an honest and reliable broker is priceless in today’s trading environment, where everyone wants a bite of what you’re chewing. A good broker should have transparent policies, should always inform you when he decides to change some of them, regardless how small the changes are, and he should be reliable.

The last thing you want is a broker craving for your money and lacking any sense of morality and honesty. This is why it is imperative to check the broker’s background and reputation before stepping into any type of long term collaboration.

2. Learn and adapt

Adaptability will come a bit later. What you need to focus on, in the initial phases, is learning as much as you can about how things work. Inform yourself on the movements of the market, which assets are hot and which aren’t, which are showing promise of becoming hot.

Learn how to predict outcomes, because that will tell you when a specific investment is worth it or not. And, last but not least, keep your mind open to everything new. Any tip or advice that could help you improve your game.

3. Always control your position

When trading with CFDs, the first mistake you are bound to make is to leave your position unsupervised. This could have dire consequences if the market decides to play a trick on you and simply slide the opposite direction.

If you don’t monitor your position up-close and personal, you won’t be able to prevent or minimize the damages in time. And eating a full blow is never fun. Even more, it could throw you in a financial grave.

4. Don’t take leverage for granted

You know how leverage works by know. You know it can deliver a lot of profit if you play it right and a lot of mess if you don’t. Treat it with respect, which means you should always go for safe bids (as safer as they can get) and look for anything that could cause you to lose your position.

Then, as soon as you have spotted the danger, move along to the next step, which is:

5. Use stop limits

Depending on the broker you might work with, you will have specific stop limits to prevent your margin account for being ripped apart by some unfortunate twist of events. Stop-losses are pretty popular among traders, because they stop the money leak and keep you on the floating line.

6. Stay modest and learn to control your emotions

One of the biggest dangers for a beginner is to fall prey to either his overinflated ego, following a series of wins, or to that kamikaze approach of going all-in, following a series of losses. Both can be extremely dangerous and can actually magnify your financial hole.

Remember that emotions have no part to play in the trading industry.

7. Stay updated with the news

The global economic sphere is extremely volatile as a whole. Sure, you have particular assets that are highly reliable, even in volatile markets. But, remember that in the trading market everything is linked to everything.

One major change in one sector can create a sudden unexpected domino effect that could send shock waves even in sectors you thought safe. You can limit those risks by remaining constantly hooked to the global news scene and adapt your game accordingly.

I have tried to be as exhaustive as I could in presenting you with all the risks you should expect. These are the most dangerous ones, because they either come with the system, like leverage, the market’s volatility or hidden brokerage clauses, or with you, the trader, like overconfidence or ignorance.

This is the reason I told you to focus primarily on the solutions, because those are the first steps you need to take on your way to become a pro.

All the precautions taken, let the games begin!

Risks With Contracts for Differences (CFD)

In finance, contracts for differences (CFDs) – arrangements made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities – are categorized as leveraged products. This means that with a small initial investment, there is potential for returns equivalent to that of the underlying market or asset. Instinctively, this would be an obvious investment for any trader. Unfortunately, margin trades can not only magnify profits but losses as well. The apparent advantages of CFD trading often mask the associated risks. Types of risk that are often overlooked are counterparty risk, market risk, client money risk, and liquidity risk.

Counterparty Risk

The counterparty is the company which provides the asset in a financial transaction. When buying or selling a CFD, the only asset being traded is the contract issued by the CFD provider. This exposes the trader to the provider’s other counterparties, including other clients the CFD provider conducts business with. The associated risk is that the counterparty fails to fulfill its financial obligations. If the provider is unable to meet these obligations, then the value of the underlying asset is no longer relevant.

Market Risk

Contract for differences are derivative assets that a trader uses to speculate on the movement of underlying assets, like stock. If one believes the underlying asset will rise, the investor will choose a long position. Conversely, investors will chose a short position if they believe the value of the asset will fall. You hope that the value of the underlying asset will move in the direction most favorable to you. In reality, even the most educated investors can be proven wrong. Unexpected information, changes in market conditions and government policy can result in quick changes. Due to the nature of CFDs, small changes may have a big impact on returns. An unfavorable effect on the value of the underlying asset may cause the provider to demand a second margin payment. If margin calls can’t be met, the provider may close your position or you may have to sell at a loss.

Client Money Risk

In countries where CFDs are legal, there are client money protection laws to protect the investor from potentially harmful practices of CFD providers. By law, money transferred to the CFD provider must be segregated from the provider’s money in order to prevent providers from hedging their own investments. However, the law may not prohibit the client’s money from being pooled into one or more accounts. When a contract is agreed upon, the provider withdraws an initial margin and has the right to request further margins from the pooled account. If the other clients in the pooled account fail to meet margin calls, the CFD provider has the right to draft from the pooled account with potential to affect returns.

Liquidity Risks and Gapping

Market conditions effect many financial transactions and may increase the risk of losses. When there are not enough trades being made in the market for an underlying asset, your existing contract can become illiquid. At this point, a CFD provider can require additional margin payments or close contracts at inferior prices. Due to the fast-moving nature of financial markets, the price of a CFD can fall before your trade can be executed at a previously agreed-upon price, also known as gapping. This means the holder of an existing contract would be required to take less than optimal profits or cover any losses incurred by the CFD provider.

The Bottom Line

When trading CFDs, stop-loss orders can help mitigate the apparent risks. A guaranteed stop loss order, offered by some CFD providers, is a pre-determined price that, when met, automatically closes the contract.

Even so, even with a small initial fee and potential for large returns, CFD trading can result in illiquid assets and severe losses. When thinking about partaking in one of these types of investments, it is important to assess the risks associated with leveraged products. The resulting losses can often be greater than initially expected.

Risks of CFD Trading

CFDs are leveraged financial products. The way a leveraged product works is as follows: A small investment amount is placed to trade a much larger position. The returns that are possible are tantamount to the returns in the underlying market. The inherent attractiveness of taking out a leveraged position is obvious: a small outlay can generate a massive return. But the flipside of this is also true: Large losses are possible. For many traders, the appeal of CFDs masks the risks associated with these products. The risks encompass multiple aspects such as client money risk, counterparty risk, liquidity risk and market risk. It behooves traders to understand the upside and downside potential of CFD trading before dabbling in this potentially lucrative contrarian investment option for real money.

Counterparty risk

The company which provides the underlying financial asset in a financial transaction is the counterparty. Whenever a CFD trader is buying or selling an option, the asset that is being traded is simply the contract that is issued by the CFD provider. Once the trader is locked in a contract, the CFD provider’s other counterparties also come into play. The attendant risk with counterparties is evident if that party reneges on its financial obligations to the trader. For example, a counterparty may not be able to meet its financial obligations thereby risking the value of the underlying asset.

Losing more than your deposit

When you trade CFDs, you are trading a highly-leveraged product. This exposes clients to risk of loss far greater than the capital invested in the transaction. Since only a small percentage of the full value of the trade is put down, clients will be liable for much more if the trade moves in the opposite direction. This is evident in the following example of a CFD trade that moves against the trader: If the margin on a CFD trade for Google stock is 2% and the CFD is worth £1000, the trader simply needs to put down £20. That is the deposit amount. The total value of the position is £980 more than that. If the price of Google stock goes against the trader by 10%, you lose £80 more (10% of £1000). This means that you have lost 4 times your initial investment in the trade. Your risk is the equivalent of having purchased £1000 of Google stock, and any market movement on that volume will affect you accordingly.

Risk of closed-out positions

Markets are highly fluid, and volatility results in up-and-down movements in prices. It is possible that price changes take place outside of regular business hours especially if you are dabbling in the international financial markets. This can cause a rapid destabilization in your account balance. In the event that an insufficient account balance exists, the trading platform will automatically close out your positions.

This will happen if the account balance drops beneath the closeout level, as indicated on the CFD trading platform. It is important to keep a watchful eye on the existing account balance, and to make additional deposits as required. Another way to avoid closed-out positions is to manually close out positions to ensure that the total margin requirements can be covered at all times.

Market risk: volatility and gapping

Since CFDs are speculative trades, they are dependent on the price movements of assets. If investors believe that the price of an underlying asset will appreciate, they will take a long position on the asset. Conversely, if an investor believes the price of an asset will decline, they will take a short position on the asset. Profits are realized when the price of the asset moves in the expected direction at the close of the trade.

However, markets are driven by a myriad of factors that even the most astute investors cannot anticipate. The macroeconomic variables in play are complex and inexplicable at the best of times. With CFD trading, a small price movement can have a dramatic effect on returns (profits or losses). Sometimes, the CFD provider may require an additional margin payment to cover the trade. If the CFD provider’s requests are not heeded, that trade will be closed out.

A contract can become illiquid if insufficient trades are being made in the market. As such, the CFD provider may request additional margin payments or simply close out that CFD contract at a price unfavourable to the trader. Since the markets move rapidly, CFD prices can fall before a trade can be concluded at an agreed-upon price. This is known as gapping. Simply put, the existing contract would take less than optimal profits. Alternatively, it may happen that the trader would have to cover the losses that the CFD provider incurs. The use of guaranteed stop loss orders, order boundaries, and others can limit risks to the trader.

Holding positions

The holding costs are tacked on to the CFD traders account on a daily basis. This occurs if you hold positions overnight beyond 5 PM New York time. If positions are held for a long time, these holding costs may eat out all of the profits that have been generated on the CFD. Again, traders need to ensure that when they are holding positions they have sufficient capital resources to cover the holding costs. The holding costs can quickly add up and erode all profits generated on the CFD trade. At that point, it will be necessary to deposit additional funds.

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