CFDs are leveraged financial products. The way a leveraged product works is as follows: A small investment amount is placed to trade a much larger position. The returns that are possible are tantamount to the returns in the underlying market. The inherent attractiveness of taking out a leveraged position is obvious: a small outlay can generate a massive return. But the flipside of this is also true: Large losses are possible. For many traders, the appeal of CFDs masks the risks associated with these products. The risks encompass multiple aspects such as client money risk, counterparty risk, liquidity risk and market risk. It behooves traders to understand the upside and downside potential of CFD trading before dabbling in this potentially lucrative contrarian investment option for real money.
The company which provides the underlying financial asset in a financial transaction is the counterparty. Whenever a CFD trader is buying or selling an option, the asset that is being traded is simply the contract that is issued by the CFD provider. Once the trader is locked in a contract, the CFD provider’s other counterparties also come into play. The attendant risk with counterparties is evident if that party reneges on its financial obligations to the trader. For example, a counterparty may not be able to meet its financial obligations thereby risking the value of the underlying asset.
Losing more than your deposit
When you trade CFDs, you are trading a highly-leveraged product. This exposes clients to risk of loss far greater than the capital invested in the transaction. Since only a small percentage of the full value of the trade is put down, clients will be liable for much more if the trade moves in the opposite direction. This is evident in the following example of a CFD trade that moves against the trader: If the margin on a CFD trade for Google stock is 2% and the CFD is worth £1000, the trader simply needs to put down £20. That is the deposit amount. The total value of the position is £980 more than that. If the price of Google stock goes against the trader by 10%, you lose £80 more (10% of £1000). This means that you have lost 4 times your initial investment in the trade. Your risk is the equivalent of having purchased £1000 of Google stock, and any market movement on that volume will affect you accordingly.
Risk of closed-out positions
Markets are highly fluid, and volatility results in up-and-down movements in prices. It is possible that price changes take place outside of regular business hours especially if you are dabbling in the international financial markets. This can cause a rapid destabilization in your account balance. In the event that an insufficient account balance exists, the trading platform will automatically close out your positions.
This will happen if the account balance drops beneath the closeout level, as indicated on the CFD trading platform. It is important to keep a watchful eye on the existing account balance, and to make additional deposits as required. Another way to avoid closed-out positions is to manually close out positions to ensure that the total margin requirements can be covered at all times.
Market risk: volatility and gapping
Since CFDs are speculative trades, they are dependent on the price movements of assets. If investors believe that the price of an underlying asset will appreciate, they will take a long position on the asset. Conversely, if an investor believes the price of an asset will decline, they will take a short position on the asset. Profits are realized when the price of the asset moves in the expected direction at the close of the trade.
However, markets are driven by a myriad of factors that even the most astute investors cannot anticipate. The macroeconomic variables in play are complex and inexplicable at the best of times. With CFD trading, a small price movement can have a dramatic effect on returns (profits or losses). Sometimes, the CFD provider may require an additional margin payment to cover the trade. If the CFD provider’s requests are not heeded, that trade will be closed out.
A contract can become illiquid if insufficient trades are being made in the market. As such, the CFD provider may request additional margin payments or simply close out that CFD contract at a price unfavourable to the trader. Since the markets move rapidly, CFD prices can fall before a trade can be concluded at an agreed-upon price. This is known as gapping. Simply put, the existing contract would take less than optimal profits. Alternatively, it may happen that the trader would have to cover the losses that the CFD provider incurs. The use of guaranteed stop loss orders, order boundaries, and others can limit risks to the trader.
The holding costs are tacked on to the CFD traders account on a daily basis. This occurs if you hold positions overnight beyond 5 PM New York time. If positions are held for a long time, these holding costs may eat out all of the profits that have been generated on the CFD. Again, traders need to ensure that when they are holding positions they have sufficient capital resources to cover the holding costs. The holding costs can quickly add up and erode all profits generated on the CFD trade. At that point, it will be necessary to deposit additional funds.