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CFD Trading Risks: Identify and address them
Swen Keller
In the crypto world Swen has consistently found success through his effective communication skills and the unique ability to navigate the details.
- Last Updated 29 August, 2024
Contract for Difference (CFD) trading is a popular form of derivative trading that allows traders to speculate on the price movements of various financial assets, such as stocks, indices, currencies, commodities, and more, without actually owning the underlying assets.
While CFD trading can offer potential opportunities for profit, it also comes with a range of risks that traders should be aware of. This guide will identify and address the risks of trading CFDs in financial markets and provide tips to minimize them.
What is CFD trading??
CFD trading is a unique way of investing your money, where you borrow funds and wager on the price movements of underlying assets without actually buying them.
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Two parties are at play here: the investor and the broker/CFD provider. Let’s elaborate!
The trader enters a legally binding contract with the broker, where the former opens a position (opens an account) with an initial margin (a security deposit). The trader bets either “long” (that the underlying asset will rise in value) or “short” (that the underlying asset will decline in value). If the trader successfully predicts the value of the underlying asset, they will make a profit, but if they end up guessing the outcome wrong and the period of time the contract is valid expires, the trader will lose money.
A key term to remember here is “leveraged trading”, which essentially refers to your purchasing power. So, for example, if your security deposit was $100, and you were lent $5,000, then your leverage will be 50:1 (you could buy 50 times more with the borrowed funds in contrast to your own money). In a nutshell, leverage enables you to control a larger position, the total value of which exceeds your initial investment many times over.
To learn more about trading CFDs, refer to this blog.
Understanding the Potential Risks of CFD Trading
A competent trader believes that meticulous analysis, risk management, flexibility, and continuous learning are essential for success while investing. This is important, especially when it comes to CFD trading since there are many risks, which we’ll explore now.
Leveraged Losses are also Multiplied
Everyone talks about how you stand to gain hundreds of times more than your original investment, but what no one tells you is how the exact opposite could also happen when engaging in any kind of trading. This is how it works: You enter a contract with a CFD provider with $500 and go long, with leverage of 10:1, so you control $5,000. The underlying asset you invest in currently stands at $10 each ($5,000/$10 = 500, so you hold 500 shares). By the time the contract expires, the shares you purchase drop in value by $0.5 each. So, $0.5 x 500 is $250, which means you lost about half of your investment money.
For perspective, if you invested $500 in the financial market directly, you would only be able to purchase 50 shares, and your loss would be just $25 ($0.5 x 50 = $25).
Additional Margin Payments
If the losses incurred exceed your initial investment, the CFD provider will ask you to deposit additional cash payments into your account via a so-called Margin-call. This is for covering potential losses in the future to keep the CFD position open. So, for example, if your initial $500 was insufficient to compensate for the losses due to price movements and you had to invest another $500 (which, likewise, could be lost if the market movements are against you). The losses will pile up as you fall down the rabbit hole.
Risk of Account Close-out
If you cannot maintain an adequate margin in your CFD trading account (this usually happens when your losses exceed your security deposit), then your broker reserves the right to terminate the existing contract. You’ll end up losing everything that you invested.
Additional Costs
In all the complexities involved in CFD trading, it is easy to overlook smaller fees that can accumulate to a potentially significant amount over time.
Platform Fees: CFD trading exchanges only let you access and operate on the platform once you have paid the requisite fee. This fee may be one-time, time-lapsed, or subscription-based.
Commissions: Aside from the initial margin, you will be charged a separate predetermined price to use the services of a CFD provider. The commission fee may also be increased to compensate for other costs, like financial regulations (anti-money laundering, data security, etc.).
Tool and Application Fee: Some platforms might also charge you additional money for using other essential services like guaranteed stop-loss orders, take-profit orders, and market data.
Currency Conversions: If the currency in your contract is different from your bank’s base currency, then you will have to pay additional costs that come with exchange rates.
Rollover Fees: If you (have to) hold your position overnight, your CFD provider will most likely charge you overnight or rollover-fees that can add up over time and eat up your potential profits.
Hidden Fees: Some CFD providers may add subtle costs to the contract or hidden fees that may eat up some of your profits, so you need to be careful about these costs by thoroughly reviewing your contract prior to signing.
Complex Contract Clauses
Novice investors can sometimes get tangled up in unfair trading contracts that are legally binding. These may cause these traders to sustain enormous financial damages. Ultimately, it all boils down to the broker’s credibility, and while most popular brokers will not do that, it is best to look out for yourself and read the contract thoroughly before signing it.
Gapping: Swift Price Shifts
Gapping means an asset can open at a significantly different price the next day than it closed on the previous day. Say a share that closed at $50 opens at $40 the next day, a considerably lower sell price. You wanted to close your position if the share price fell below $47, but you could no longer do that because of the huge price jump overnight. This can cost you a lot of money because remember, leveraging can increase your losses exponentially.
Counterparty Risk
We can not stress enough how vital a broker’s credibility is. Counterparty risk means that one of the parties in a contract defaults on their contractual obligations. So, for instance, even if you successfully close your position at a profit, the broker may not be able to transfer your profits due to financial difficulties. This highlights the imminent need to address regulatory gaps in the CFD market and mitigate these underlying security risks that come with it.
How to Mitigate Risks When Trading CFDs
Looks like we might’ve scared you out of trying CFD trading altogether with so many risks involved. However, despite the risks involved, it continues to be a popular trading technique. Trading CFDs can be quite profitable if you adopt the right trading strategies. Here are some ways you could avoid losses.
Know Your Limits: Knowing how much you can afford to lose without significantly affecting your financial situation is critical because it prevents you from risking your livelihood.
Use a Demo Account: Use a demo account to familiarize yourself with market trends, visualize finances, and prepare yourself to react immediately based on sudden market movements.
Use Stops and Limits: A stop-loss order is a handy feature that closes your position if you lose money at an unprecedented rate due to market fluctuations.
Practice Risk Management: Prudent risk management requires you to study trends, analyze market risk, follow a trading plan, develop trading strategies, and take adequate action when needed. Using this protocol in trading CFDs can significantly cut down your losses.
Use Tools: Employing tools, such as charts (and chart explorers), analytical tools, position sizing calculators, volume indicators, etc., can assist you in successfully benefiting from trading CFDs.
Please remember that these strategies can minimize risks, but they do not guarantee a loss-free trading experience. Additionally, choosing the right broker is the most crucial step when you trade CFDs, which requires its own guide. Read more about crypto CFD providers in this blog.
Top CFD Brokers with Risk Management Tools
Trading CFDs is inherently risky, so choosing a platform with the right risk management tools is crucial in mitigating losses. Here are the top CFD trading platforms with risk management tools.
Plus500 is the top choice for risk mitigation features. It offers industry-standard risk management tools such as Close at Profit (Stop Limit), Close at Loss (Stop Loss), and Trailing Stop orders. It also offers a custom function, the Guaranteed Stop, which adds an absolute limit on your potential loss. So your position will be closed at a particular price with no risk of slippage.
The FxPro CFD broker offers regular Stop Loss and Take Profit orders with Market Execution. This means that once your order is executed, it is filled at the current market price, which can be above or below the requested price during periods of high volatility.
AvaTrade offers a unique risk management tool called AvaProtect that allows you to protect a particular trade against losses of up to $1 million over a chosen period in exchange for a hedging fee charged at the point of purchase.
Final Verdict
CFD Industry holds tremendous potential for investors looking to make quick cash in a short time. It only requires a slim amount of capital to begin trading and allows you to engage in significant trades. Although there is potential for immense profit, the risks involved are equally devastating.
Tread carefully with risks such as shrewd contracts, account close-out, and counterparty risk. Excellent decision-making skills and great intuition are key characteristics needed by CFD traders. If you equip yourself with the right tools, take investment advice from the experts, and watch your every step, CFD (Contract for Difference) trading can indeed be a profitable venture for some traders
FAQ
Most frequent questions and answers
Yes. While CFD trading is based on the market movements of stocks, the chances of you losing money is the same in both scenarios. However, since the money at stake is significantly higher in CFD trading compared to trading stocks, even slight market movements can cause you massive financial losses.
CFD trading has several downsides, like losses that may occur overnight, liquidity risk, gaps and slippage in the underlying asset, rollover adjustment, low industry regulation, and volatility of the financial markets.
Definitely! Just like any form of trading, you can lose money when your trade CFDs. Losses are usually amplified due to leveraged trading in CFD trading. Therefore, a trading plan is necessary to counter sudden market movements and risks.
82% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.
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