The risks of CFD

In the financial sector, a contract for difference (CFD)-an arrangement made in a futures contract to settle differences through cash payment rather than the delivery of physical objects or securities-is classified as a leveraged product. This means that with a small initial investment, it is possible to obtain a return comparable to the underlying market or asset. Instinctively, this is an obvious investment for any trader. Unfortunately, margin trading can amplify not only profits but also losses.

The obvious advantages of CFD trading often mask the associated risks. The types of risks that are often overlooked are counterparty risk, market risk, customer fund risk, and liquidity risk.

Key points

  • Contracts for Difference (CFD) allow traders to exchange the difference in the value of financial products between the opening and closing of a contract without the actual underlying securities.
  • CFDs are very attractive to day traders, who can use leverage to trade assets with higher buying and selling costs.
  • Due to lax industry regulation, possible lack of liquidity, and the need to maintain sufficient margin due to leverage losses, CFDs may be quite risky.

Counterparty risk

Counterparties are companies that provide assets in financial transactions. When buying and selling CFDs, the only asset traded is the contract issued by the CFD provider. This exposes the trader to the provider’s other counterparties, including other customers with whom the CFD provider does business. The related risk is that the counterparty fails to fulfill its financial obligations.

If the provider is unable to fulfill these obligations, the value of the underlying asset is no longer relevant. It is important to realize that the CFD industry is not highly regulated, and the reputation of brokers is based on reputation, longevity and financial status, rather than government status or liquidity. There are excellent CFD brokers, but it is important to investigate the background of the broker before opening an account. In fact, according to current US regulations, US customers are prohibited from trading CFDs.

Market risk

CFDs are derivative assets used by traders to speculate on changes in underlying assets (such as stocks). If it is believed that the underlying asset will rise, investors will choose a long position. Conversely, if investors believe that the value of the asset will fall, they will choose a short position. You hope that the value of the underlying asset will move in the direction that is most beneficial to you. In fact, even educated investors can be proven wrong.

Unexpected information, changes in market conditions, and government policies can lead to rapid changes. Due to the nature of CFDs, small changes can have a large impact on returns. An adverse effect on the value of the underlying asset may cause the provider to request a second deposit payment. If the margin call cannot be met, the supplier may close your position, or you may have to sell at a loss.

Client funds risk

In countries/regions where CFDs are legal, there are client funds protection laws to protect investors from the potentially harmful practices of CFD providers.According to the law, the funds transferred to the CFD provider must be separated from the provider’s funds to prevent the provider from hedging its own investment. However, the law may not prohibit the client’s funds from being transferred to one or more accounts.

When the contract is agreed, the provider withdraws the initial deposit and has the right to request further deposit from the collective account. If other customers in the collective account fail to meet the margin call requirements, the CFD provider has the right to make a draft from the collective account that may affect returns.

Liquidity risks and gaps

Market conditions affect many financial transactions and may increase the risk of loss. When there are not enough underlying asset transactions in the market, your existing contracts may become illiquid. At this time, the CFD provider may require additional margin payment or close the contract at a lower price.

Due to the rapid changes in the financial market, the price of a CFD may fall before your transaction is executed at a previously agreed price (also known as a gap). This means that holders of existing contracts will need to earn less than optimal profits or make up for any losses suffered by the CFD provider.

Bottom line

When trading CFDs, stop-loss orders can help mitigate obvious risks. The guaranteed stop loss order provided by some CFD providers is a pre-determined price, and when it is reached, the contract will be automatically closed.

Even so, even if the initial cost is small and it is possible to obtain huge returns, CFD trading may also result in insufficient liquidity of assets and serious losses. When considering participating in one of these investments, it is important to assess the risks associated with leveraged products. The resulting losses are often greater than initially anticipated.

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