What are the risks in CFD trading?

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risks in CFD trading

Contract for difference (CFD) is a leveraged instrument that allows you to trade the market movement of an underlying asset without owning it. 

CFD trading has become increasingly popular with the increased numbers of online brokers, however, there are a number of countries that have banned the trading of CFD because of its high-risk nature. 

How is CFD traded?

CFDs can be traded on underlying assets such as indices, shares, commodities and foreign exchanges. They are traded on margin and what this means is that usually a trader only pays 5-20% of the traded value. 

For example, if a trader wants to buy one share of Facebook at $250, the brokerage requires the trader to have the deposit equivalent to one Facebook share which is $250. 

However, if the trader buys one Facebook CFD, he no longer requires the full $250 and will only need to fork out 5 – 20% of that amount to purchase the CFD if the price of Facebook drops subsequently, the trader must have enough money in his/ her account to ensure that he would be able to pay for the losses. 

If there is a shortage of funds, the trader would have to top up his account in order to keep the position, or the positions will be automatically closed.

The risks of CFD trading 

CFD trading requires thorough research because it can be complicated and is usually best left to experienced traders. The best way to mitigate losses of CFD trading is to understand the potential risk of leveraged financial instruments. 

1. You risk losing more than your capital

Leveraged products allow you to trade the full value of the underlying asset by paying only a small percentage. Although you can accelerate your profits by taking a larger position even with a small capital, you can also amplify your losses as you might lose more than you have deposited. 

Traders who take on much bigger positions than their capital allows are at risk of magnifying their losses if the trade does not go according to plan.

2. Price Slippages and Market Gaps

The financial markets are volatile and traders may occasionally face some of the negative consequences of high volatility while executing trades. 

Pricing slippages may occur during times of high volatility, resulting in the actual transaction price being high or lower than intended due to rapid price fluctuations. 

Market gapping can also occur during volatile periods, where a large volume of orders causes prices of an asset to move drastically without stopping at any of the prices in between. 

These can lead to traders experiencing large losses. Market gapping can occur due to unexpected economic or political news events which can cause drastic market changes.

Price Slippages
Photo by Ruben Sukatendel on Unsplash

3. Account close-out risk

Depending on the market you are trading in, a margin call could occur outside of normal trading hours. 

A margin call happens when prices have moved against a trader’s favour and the brokerage needs to ensure that your account has sufficient funds to cover the losing position. In the case that you do not top up the amount in your account, your position would be automatically closed out. This also acts as risk management for both the broker and the trader.

4. Holding charges can accumulate

CFDs are often used for day trades because holding them overnight incurs a swap fee charged by brokerages. Swap fees depend on brokerages and can accumulate if a trader is trying to hold out their position for a long time to tide through losses. The accumulation of swaps could mean increased losses for the trader. 

5. There are counterparty risks

A CFD trade does not carry any underlying assets as what is traded between you and a broker is merely a contract. There are risks that are associated with the broker and the other parties that trade with the broker. 

If a broker and its counterparties are not able to fulfill the financial obligations of the contract, the value of the underlying asset would be irrelevant. 

There are varying regulations around CFD industry in different countries, and traders should make sure to choose a reputable broker. Brokers may not act in your interest when executing buy or sell orders by delaying them and closing at a less favourable price. 

Conclusion

CFDs are high-risk financial instruments and it is recommended more for experienced investors. 

Start your trading small to get a better understanding of the market and develop a trading and risk management plan.. 

Risk management tools to set boundaries for limits and stop-losses can help reduce sudden significant losses. 

The article is a part of our comprehensive series on “What is CFD trading?

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