The Risks You Face with CFD

The ultimate list of CFD trading risks

CFDs are leveraged financial instruments. They are futures contracts that hinge on shifts in the price of underlying assets rather than speculations on the value of the assets themselves. Settlements in cash are made between contracted parties, so the price shifts one way or the other and one of them wins while the other loses. Both parties can participate with only a small initial investment, and there is the potential for returns which equate to shifts in the underlying asset or market (yes, wagers on shifts in markets themselves can be made too). On this basis, a CFD would seem to be the most obvious investment vehicle for any trader, but the element of margin means that it’s not just profits that are magnified. Losses are exponentially greater too. All of the benefits of CFD trading come with an elevated level of risk that is sometimes ignored by overenthusiastic traders. But they would do well to be wary of the risks associated with liquidity, the counterparty, the market, and client money.

Counterparty Risk

The counterparty is the person on the other side of the contract; the person being bet against. When you open a CFD you expose yourself to the CFD providers’ other clients. This means you put yourself at risk of that individual failing to fulfil their financial obligations to you. Regardless of how the asset performs, you will lose out if the person you’re betting against fails to uphold their end of the bargain.

Market Risk

Although there’s no need to take delivery or ownership of any underlying assets in CFD trades, their volatility is obviously the key component of any deal. If you believe that they’ll fall in value, then you will take a short position. If you believe that they will rise in value, then you take a long position. You’re simply gambling on the direction that the price will move, but unless you can predict the future with 100% accuracy, the only certainty is that at some point you will be wrong, and this will cost you money.

CFD trading is like a succession of coin tosses, and things like changes in markets, world events and government legislation can quickly turn the tide against you. Even small changes can have a big impact on returns, and indeed on the balance of your trading account. You can be sure that your provider will be quick to request immediate funds when things turn sour, and they may even close your position or leave you with no choice but to sell at a loss.

Client Money Risk

CFDs are not legal in all countries, but where they are, there are laws in place to protect client’s money so that investors aren’t exposed to poor practices by CFD providers. The law requires that funds delivered to a CFD provider must be kept separately from the provider’s own, to stop them from hedging their own investments. But the law still might not stop the provider from aggregating client moneys to their own benefit anyway. When a contract is set up, the provider takes out a margin and may request additional margins from the aggregated account. If the other clients in the pooled account don’t meet margin calls, the CFD provider is allowed to draw from the pooled account, which could lower profits.

Liquidity Risks and Gapping

Many financial transactions are affected by market conditions, which can raise the risk of losses. When there aren’t sufficient trades in the particular underlying asset being made in the market, this may make your existing contract illiquid. When this happens, a CFD provider may insist that additional margin payments be made or that you close contracts and take losses.

Another issue is gapping. Some markets can move so quickly that between the time that you agree a price for a trade and the trade is actually executed, it falls. When this happens the holder of an existing contract would need to accept lower profits or fill in the financial ‘gap’ that the CFD provider experiences.

Stop Your Losses

With CFD trading, stop-loss orders become an essential risk management tool. Some CFD providers offer a guaranteed stop-loss order, which means the contract closes at a predetermined price. Despite this, and even with a minimal initial set up fee and potentially hefty returns to be had, CFD trading can leave you catastrophically deep in the red. It essential to do your homework before you go anywhere near one of these leveraged products.

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