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What are the risks of contract for difference (CFD) trading?
CFD trading can be lucrative, but there are many risks to watch out for.
A Contract for Difference (CFD) is a highly leveraged, complex product which is ideally suited to very experienced traders and investors. CFDs can be highly lucrative and provide an opportunity to make a lot of money quickly, but you can also lose a lot of money just as quickly if you’re not experienced. This guide covers the risks involved with CFD trading.
What is CFD trading?
CFDs allow traders to speculate on the value movements of a large range of financial products and assets – anything from share prices and currency pairs to the price of gold or oil. CFD traders do not own the underlying asset, nor are they trading the asset itself but are instead speculating on whether its value will increase or decrease. For more information on CFDs, check out our Guide to CFD trading in New Zealand.
What are the risks of CFD trading?
CFDs can seem appealing as you have the potential to earn a lot of money quite quickly. This is because they are highly leveraged, so even though you only need to put forward a small margin of the complete trade value to initiate a trade, you can still benefit from 100% of potential gains. However, there are many risks involved, which are detailed in this section.
CFDs are complex
CFDs are complex products so there’s room for misunderstanding and trading errors. While investing in shares is a strategy suited to both new or experienced investors, CFDs are best left to highly experienced traders.
You could lose more than your initial capital
If you put $50 into a pokie machine, the most you stand to lose is $50. However, with CFD trading you could lose more than you originally invested. Trading CFDs is riskier than traditional share trading as you’re trading with leverage. Traders are only required to put forward a small amount of the total trade value, often only 5%. However, if the trade goes in their favour, they are entitled to 100% of the profits. However, the reverse is also true: Traders are responsible for 100% of the losses too. Let’s look at the fictional example below.
Imagine a trader buys 4000 CFDs at $5 per order, for a total of $20,000. The CFD has a margin of 5%, meaning the trader only pays $1000 to open the trade (ignoring possible commissions). The trader believes the price of the share is going to rise in value, so they go long on this trade. If the price of the underlying share the CFD is speculating on rises or falls in value, the table below shows possible gains and losses.
|If the price of the share||To||You could gain|
|Rises by 20%||$6.00||$3934.00|
|Rises by 10%||$5.50||$1937.00|
|Rises by 5%||$5.25||$938.50|
|If the price of the share||To||You could lose|
|Falls by 5%||$4.75||$1058.50|
|Falls by 10%||$4.50||$2057.00|
|Falls by 20%||$4.00||$4054.00|
If the margin was lower than 5% the risk becomes even greater. In addition to any losses, this table doesn’t take into account any potential commissions, fees or interest the trader may need to pay.
CFDs are contracts
When trading CFDs, you’re buying a contract between you and the CFD provider. The contract outlines your speculations about the value of the financial product or underlying asset and is a legally binding agreement. Unless you have some trading knowledge, and the time and patience to digest the provisions of the contract, you could get stung by a hidden clause.
The CFD provider may not act in your best interest
Not all CFD providers act in the best interests of clients, which is referred to as counterparty risk. For example, there may be a delay between when you place a CFD order and when the provider executes it, which might mean your order is executed at a price which is worse, potentially costing you big dollars. If your trade is making a loss, your CFD provider could close out your trade at a loss without consulting you. The opposite is also true: you could implement a stop-loss order to try to protect yourself from losses, but the CFD provider may not honour this and might keep your trade open even longer. Because of these factors, the success of a CFD trade doesn’t just rely on your ability to make correct speculations and assumptions on the value movements of assets, but it’s also dependant on the CFD provider you use.
Your money might be held with other traders’ money
Every CFD provider has their own terms and conditions, but your money is typically covered by the law against a CFD provider misusing your funds. Some CFD providers may pool your money into one account, mixed with money from other investors. They are then permitted by law to withdraw some of this money in the form of an initial margin and also a further margin if they need to. If your CFD provider withdraws this money it’s no longer protected by the law, as it’s no longer in a client account and therefore counted as client money. If your money is pooled with other investors, there’s an additional risk if one client fails to pay the money they owe in the event they lose a trade. This could delay your payments as the pooled account is in deficit.
CFDs can be affected by market conditions
Because you’re speculating on the price movements of financial assets, such as shares, your trade is affected by broader market conditions. However, because CFDs are highly leveraged, even a tiny dip in the market can result in not-so-tiny losses. Trading CFDs could become even riskier if you’re trading during times of economic uncertainty, such as major political elections. However, even if the market is stable, there are often unpredictable, seemingly random events that affect the price movements of various financial products, making it almost impossible to predict for even the most experienced traders.
CFDs can move quickly
This is called ‘gapping’ and refers to the idea that a CFD can move in price between, for example, $5.50 and $6.00 without stopping at any of the price points in between. Therefore, even if you’d planned to close a trade at $5.55, you might not get a choice. Because the prices move so quickly, this opens up traders to increased risk.
How to mitigate these risks when trading CFDs
CFDs are a high-risk strategy and this is reflected in the strong warnings regulatory bodies such as the Financial Markets Authority place on them. Most investment strategies have an element of risk, and it’s essential to understand what they are and what you can do to mitigate these risks before you begin trading. Here are some strategies to mitigate the risks of trading CFDs:
Do your research.
Like any investment, it’s important to do lots of research before you begin. The more you understand about the ins-and-outs of CFD trading and the risks involved, the better.
Select asset classes that you have experience with.
It’s a good idea to trade CFDs with underlying assets you understand and have experience with. For example, if you have lots of experience with share trading and understand what factors affect share prices, you could consider trading share CFDs to begin with.
It can be tempting to go big when you first start but remember when trading with leverage if you have the potential to gain a lot, you also have the potential to lose a lot. Trading in small sizes, to begin with, is a good way to get comfortable trading with leverage. It also means that if your trade doesn’t go as planned, you only lose a small amount.
Open a free demo account.
Before committing your own money to a trade, why not take advantage of one of the free demo accounts offered by a number of CFD brokers on the market? IG Markets and Plus500 offers a demo account that allows you to practice executing trades in a simulated environment, providing you with an opportunity to test strategies and learn the mechanics of trading without risking any of your own capital.
Use stops and limits.
Tools such as stop losses and limit orders are a great way to minimise your risk, as they effectively allow you to cap your losses at a specific amount. These tools are a good way to protect traders against sudden or unexpected market movements and are offered by most CFD trading providers.
Understand what you can afford to lose.
As CFDs are highly leveraged products, you can lose a lot more than your initial capital used to place the trade. It’s essential to understand how much money you can comfortably afford to lose, so in the event that your trade doesn’t go well, you’re not losing more than you can afford. If you have done plenty of research and have extensive trading experience, you can compare CFD providers in our table below.
Compare CFD platforms
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