Potential Risks of
CFD Trading

Potential Risks
of CFD Trading

A CFD (or Contract for Difference) is a highly specialised and extremely popular financial instrument. They allow you to trade price movements of various financial assets without actually acquiring or owning them. The most common financial products that are traded include currency pairs, metals, commodities, indices, shares and cryptocurrencies.

Trading CFDs involves several parties. There is the investor (trader) who is looking to purchase the CFD and the counterparty that is providing the asset in the transaction. Depending on where the financial instrument is being traded an intermediate party such as a CFD broker, investment bank or spread betting firm may be involved. The contract involves an agreement by both the involved parties to exchange the difference in the value or price of the underlying asset, from the time the contract is opened to the time it is closed.

The immense popularity of CFD trading stems from the many advantages offered by this financial instrument. There are, however, certain risks involved. As is the case with any form of trading, it is important to understand the risks and make informed decisions. Before looking at the benefits and risks of CFD trading, let’s first try to understand how this financial instrument actually works.

How Does CFD
Trading Work?

When trading CFDs, you never buy, own or sell the financial asset. Instead, you enter into a contract depending on whether you expect the price of the underlying financial asset to rise or fall. For example, if the price of gold is $2,000 per ounce and you expect the price to rise, you may enter into a long position. Let’s say the market moves in your favour and the price of gold rises to $2,010. This means you have earned $10.

In a traditional trading environment one would have purchased an ounce of gold, waited for the price to rise and then sold the gold to make a profit. This is where the clear distinction of traditional trading and CFD trading is drawn. With CFD trading, you do not need to purchase the ounce of gold to profit from a rise in its value. Instead, you simply enter into a contract relating to its future price. When the contract period ends, only the difference between the prior price and the current price is exchanged between the two parties. In our example, $10 will be credited to your trading account.

Conversely, if the market moves against you and the price of gold falls to $1990 per ounce, $10 would be debited from your trading account. In other words, you have gained exposure to one ounce of gold without having to make an initial investment of $2,000. This is a simplified example and there are a few things to bear in mind with CFD trading. We will cover these as we explain the advantages and potential high risks associated with CFD trading.

What are the
Advantages of
CFD Trading?

CFDs were introduced in London in the early 1990s. They were originally a type of equity swaps that were traded on margin. Since the turn of the millennium, CFD trading spread through the global markets and across asset classes. Over the years, they have gained immense popularity with an increased amount of CFD providers.

Here are some of the basics when it comes to trading CFDs. Their price is calculated based on the movement in the price of the underlying asset between trade entry and exit. Only the change in price is computed, without considering the value of the underlying asset. The initial margin is then calculated by multiplying the difference between the entry and exit prices by the amount of the financial instrument that is purchased.

Taking the example of gold again, if you expect the price to fall, you can open a CFD to go short. If the market moves in your favour and the price falls to say $1,990 per ounce when your contract ends, you make a profit of $10, although the market is falling. Purchasing a contract for 10 ounces would result in a profit of $100. During the initial months of the covid-19 outbreak, we witnessed a unique financial situation with the price of financial instruments such as indices and oil severely hit.

The uncertainty across global stock markets brought about an increase in market risk and volatile market conditions. For retail investors volatility is considered to bring about a high level of risk due to an increase in potential losses. This is not the case for experienced traders who will trade CFDs using a particular trading strategy that may include having a guaranteed stop-loss order.

Thanks to CFD brokers and specialised trading platforms, investors can now access thousands of financial instruments across global markets. One of the main attractions of CFD trading through a broker is that they offer highly leveraged products. This allows traders to magnify their exposure to a financial instrument without increasing their capital investment. It all sounds too good to be true so let's take a closer look.

What are the
Potential Advantages
and Risks of CFD
Trading with
Leverage?

With leverage, you can open a large position by committing only a small percentage of the total value of the trade. Some brokers offer leverage as high as 30:1. What does leverage really mean? In simple words, it is like a loan that the broker offers you. Let’s say you expect the EUR/USD currency pair to climb by 100 pips from 1.1898 to 1.1998. You have $1,000 but your CFD broker offers an account leverage of 10:1. This means you can gain exposure of $10,000 for this trade despite only having an initial investment balance of $1,000. If the market moves as you estimated and the pair does add 100 pips, your profit will be $100.

Without leverage, you would have had to invest $10,000 to profit $100 from the above scenario. This translates to a return on investment of 1%. However, since you used the 10:1 leverage offered by your broker, you could make a profit of $100 by investing only $1,000. This equates to a return on investment of 10%!

In regions such as the UK and Australia, some CFD brokers offer leverage of 30:1. If applied to the above scenario, one could invest $1,000 and gain exposure to $500,000. Again, if the market moves as you estimated and the pair adds 100 pips, your profit will be $5,000 and your return on investment will be 500%. That’s a great opportunity! However, it comes with elevated risks. Since your exposure is significantly higher with leverage, any potential losses will also be magnified if the market moves against you. This means you can lose much more than what you had committed. It is always a good idea to read any product disclosure statement (PDS) prior to using such a trading system.

How to Limit the Risk Associated
with Leverage in CFD Trading?

Risk management is one area that separates successful and experienced traders apart from the rest. Here are some things to consider:

Increasing your knowledge of CFD trading can only help, but there is no substitute to hands-on trading experience. Before you begin trading CFDs, consider opening a demo account which allows you to use trading platforms with virtual currency. Become accustomed to share trading and observe high risk financial markets in real-time before proceeding to open a live account.

Another way to limit risk is by placing stop loss orders with each trade. This will ensure that your order closes if the market suddenly moves in the opposite direction to what you had expected. Placing stop loss enables you to curb potential losses if the market moves against you.

Other Potential Risks
of CFD Trading

Apart from leverage, there are several other types of risks to consider in CFD trading.

Risk of Associated Costs

This is not a risk per se, but often traders tend to forget their impact when calculating the value of a trade. There may be several costs involved with executing a trade including commission, spread, holding costs, platform subscription and other fees.

Here are some common costs associated with CFD trading:

Spread

This is the difference between the buy price (also known as the ask price) and sell price (also known as the bid price) of a financial instrument at any given point in time. The buy price of the asset is typically higher than its sell price. Let’s say, the spread of a security is $30.50~$30.90. If you decide to go long, you buy the security at $30.90. If you sell it immediately, you incur a loss of 40 cents. When the sell price reaches $30.90, you break even, although the sell price has risen. It’s only when the sell price rises above $30.90 that you book a profit.

Commission

Some brokers charge a fee when you enter a position and when you exit the trade.

Holding Costs

If you have open positions in your account at the end of the trading day, they incur some holding costs. Also called rolling or swap fees. The costs depend on the number of open positions in your account and how long you hold them.

How to Limit the Risk of Costs in CFD Trading?

In order to maximise profits, you should choose a forex broker that offers the tightest spreads and charges the lowest fees.

Risk of Volatile Markets

There are a number of factors that impact the financial markets. Some asset classes are inherently more volatile than others. Volatility is not always a bad thing for traders, as it creates more attractive trading opportunities than a flat market. However, a sudden rise or fall in prices can severely impact your profits.

How to Limit the Risk of Volatile Markets
in CFD Trading?

Portfolio Diversification

Portfolio diversification is the most effective way to limit the impact of volatility. This means including several different asset classes in your portfolio in order to edge against any potential market movements.

Knowledge

Experienced traders have the benefit of knowing market conditions or news that would increase volatility. For instance, the release of the NFP (non-farm payrolls) report by the US Labor Department on the first Friday of every month typically causes strong price movements. The global forex market tends to experience higher levels of volatility on the few hours either side of the release of the report. New traders may choose to close positions during this time and wait for the market to settle before resuming trading.

Stop-Loss Orders

Placing stop-loss orders for every trade ensure that a cap is placed on any potential losses. This is strongly advised for traders of all skill levels and a focal point in any trading strategy.

Risk of Closure of Positions

If your account does not have enough funds to cover your total margin requirements, your CFD broker or the trading platform that you are using, may close some or all of your open positions. When considering the funds in your account, apart from the margin requirements, brokers will also consider all the fees and charges. When holding multiple positions over a few days, you may fall short of funds in your account in case the price movements are going against your favour.

How to Limit the Risk of Closure of Positions?

Monitor your open trades and your account balance. You can add more to your trading amount whenever you have the slightest doubt of not being able to cover the total value of all your open positions. Inexperienced traders should avoid having too many open positions at a single point in time as a quick shift in market prices could result in significant losses.

Risk of Low Liquidity

There is also the possibility that the underlying asset becomes less liquid. This could be due to some unexpected news or a major event in the domestic or global market. In addition, if the demand for the asset declines, the CFD may become less liquid. If this were to occur you may not get the right opportunity to exit your trade at the desired price.

Slippage refers to the difference between the price at which you wish to exit a trade and the price at which the trade is executed. This can occur during periods of high volatility or when there is low liquidity in the market. Slippage does not always mean you incur a loss. It can move in a favourable direction for you. The risk is that the movement is unexpected and something that the trader did not account for when making a decision.

How to Limit the Risk of Low Liquidity?

The best indicator of liquidity is the spread, or the difference in the bid and ask price. When the spread is tight you can rest assured that there is ample liquidity in the security. You need to monitor the liquidity of your security in case the underlying asset is not a highly traded one. An example of this is an exotic currency pair such as the USD/TRY (the US dollar versus the Turkish lira) or the EUR/HUD (the euro versus the Hungarian forint). The best way to avoid liquidity risk is to trade in popular financial instruments and to do so with a reputed and regulated CFD broker.

Risk of the Broker Using Client Money

There a several brokers who are not regulated by any country’s authority. In such cases, there is nothing to prevent these brokers from using the money deposited by clients into their trading accounts. In fact, some brokers ensure that all investments by their clients go into a single bank account which is owned by the broker. This means there is no difference between the broker’s own funds and its client’s investments. These brokers may use client funds in any way they desire - to meet expenses, repay debts, emerge from bankruptcy or even to place trades on their own. Trading with a CFD broker that segregates client money is strongly recommended.

How to Limit the Risk of the Broker Using Client Money?

Always trade with a broker that is regulated by one of the leading regulatory authorities, like the FCA (the UK’s Financial Conduct Authority), the CySEC (Cyprus Securities and Exchange Commission) and the ASIC (Australian Securities and Investments Commission). Such regulatory authorities make it mandatory for brokers to maintain segregated accounts. This means the broker holds their own funds in a banking account that is completely delineated from the accounts of their clients. Brokers maintaining segregated accounts cannot use their client funds for anything other than enabling the respective client to trade and covering the client’s margin requirements.

Regulated brokers must adhere to strict compliance regulations or face severe penalties from regulatory authorities for any malpractices.

Risk of a Delay in Order Execution

Making money with CFD trading not only depends on your knowledge and the ability to make the right decisions, but also on how quickly an order is executed after you place it. Since the financial markets tend to move fast, any delay in order execution can mean lost opportunities or the order being executed at a less-than-preferred price.

How to Limit the Risk of a Delay in Order Execution?

Always trade on a fast and robust platform. The most popular trading platforms are MetaTrader 4 (MT4) and MetaTrader 5 (MT5).

Ensure that you are working on a machine and with an internet connection that are fast. Any lag in your computer or fault in your internet connection can cause a delay in order execution.

Make sure your broker offers you the best trading conditions, including ultralow latency execution, tight spreads, minimal slippage, and best possible prices. Choose a broker that offers deep liquidity and ensures top quality of your order executions, with speed and accuracy.

What Measures Can
You Take to Control
Risk Exposure When
Trading CFDs?

The potential risks associated with CFD trading have been discussed above, along with possible ways in which you
can minimise them. Here are a few more general steps you can take to reduce your risk exposure with CFD trading:

Learn about the underlying asset

You will make better CFD trading decisions if you are familiar with trading the underlying asset. Learn about the factors that impact its price. Read charts and analyse how the underlying asset has moved in the past.

Practice with a demo account

Choose a broker that offers a free demo account to enable you to practice CFD trading without using your own capital. The demo account simulates live trading in a real-time environment. This allows you to get familiar with the platform, choose the CFDs you are most comfortable with and try out various strategies. Once you gain enough confidence and understand the nuances of CFD trading, you can begin live trading.

Keep minimal open positions overnight

Your work is not over once you place a trade. Unexpected market movements can see significant fluctuations in your orders. It is a good idea to place only as many open positions as you can comfortably monitor. With overnight positions, traders should also keep in mind the potential impact of gapping.

Use stop loss and limit orders

You do not want any unexpected event or sudden market volatility to result in significant losses on your CFD position. The best way to restrict such losses is to make a habit of placing stop-loss and limit orders with every position you open.

The Bottom Line

CFD trading offers a wide range of opportunities. Investors can take advantage of rising and falling markets with most CFD brokers providing access to higher levels of exposure with leveraged products. However, for a trader who is new to CFDs, it is important to make risk management an integral part of their trading strategy.

Prices tend to move fast in the world of CFD trading meaning it is important to keep your emotions in check. It can be the difference between success and failure. Both fear and greed can lead to wrong decisions, while the presence of mind and the ability to make quick decisions are major advantages. CFD traders need to be disciplined, remain objective and stick to their trading strategy.

Source - database | Page ID - 954

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