Risks of CFD trading

24 January 2013

There’s no doubt this is a risky business. A contract for difference, or CFD, is a legally-binding contract between two parties, buyer and seller, where the seller agrees to pay the buyer the difference between the current value of an asset and its value at contract time.

Here are the main reasons CFDs don?t suit everyone:

Magnified returns, magnified risks

When pondering the suitability of CFDs in your trading life, first take the Sleep Tight Test. Could you enjoy a peaceful night?s sleep after you did the following:

  • Bought 10,000 of $10 shares, worth $100 000
  • Had only $5 000 cash in your account
  • Banked on the stock increasing 10 cents (total of $1,000 or 20% return on investment)
  • Saw the stock price drop 10 cents (loss of $1 000 or 20% of your investment)

The stock price would only need to drop by 50 cents before you would lose all your investment. Obviously, you would expect a margin call beforehand, as the money in your cash account would be insufficient. And all this while you were sleeping!

You could lose more than you have

The volatility of the stock market plus the extra leverage on your investment is a combination that can result in a much faster alteration of your overall investment position. Most people who trade CFDs are full time traders or those who have enough time to monitor their investment on a regular basis. Sudden movements on the stock market will greatly impact the CFD trader’s position and it requires immediate action, based on individual investing style. Features such as stop-loss may help some traders to minimise this risk.

Counterparty Risk
This is an additional risk that most investors need to understand, even experienced share traders. Counterparty risk refers to the risk if a CFD provider collapses and uses your deposited money as an unsecured loan to meet their liabilities or margin requirements. Many providers manage risk for clients in different ways, such as separating client’s assets and company’s assets. Check with your CFD providers for a full explanation of their risk management plans, including counterparty risk.

Forget CFDs if:

  • you are looking for a ‘set & forget’ investment
  • you don’t have time to manage your investment
  • you don’t know much about investing
  • you are not disciplined and don’t have an investing strategy/plan
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