Webp.net-resizeimage (6)

What are the Risks of CFD Trading?

CFD trading can be lucrative, but there are also things to watch out for. Learn what risks are involved before you begin trading CFDs.

A Contract for Difference (CFD) is a highly leveraged, complex product which is ideally suited to very experienced traders and investors. CFDs can be highly lucrative and provide an opportunity to make a lot of money quickly, but you can also lose a lot of money just as quickly if you’re not experienced. This guide covers the risks involved with CFD trading.

What is CFD trading?

CFDs allow traders to speculate on the value movements of a large range of financial products and assets – anything from share prices and currency pairs to the price of gold or oil. CFD traders do not own the underlying asset nor are they trading the asset itself but are instead speculating on whether its value will increase or decrease. For more information on CFDs, check out our guide: What is a Contract for Difference (CFD)?

What are the risks of CFD trading?

CFDs can seem appealing as you have the potential to earn a lot of money quite quickly. This is because they are highly leveraged, so even though you only need to put forward a small margin of the complete trade value to initiate a trade, you can still benefit from 100% of potential gains. But there are many risks involved, which are detailed in this section.

  • CFDs are complex

CFDs are complex products so there’s room for misunderstanding and trading errors. While investing in shares is a strategy suited to both new or experienced investors, CFDs are best left to highly experienced traders.

  • You could lose more than your initial capital

If you put $50 into a pokie machine, the most you stand to lose is $50. However, with CFD trading you could lose more than you originally invested. Trading CFDs is more risky than traditional share trading as you’re trading with leverage. Traders are only required to put forward a small amount of the total trade value, often only 5%. However, if the trade goes in their favour, they are entitled to 100% of the profits. But the reverse is also true: traders are responsible for 100% of the losses too. Let’s look at the fictional example below, courtesy of ASIC’s Moneysmart website. Imagine a trader buys 4000 CFDs at $5 per order, for a total of $20,000. The CFD has a margin of 5%, meaning the trader only pays $1000 to open the trade (ignoring possible commissions). The trader believes the price of the share will rise in value, so they go long on this trade. If the price of the underlying share the CFD is speculating on rises or falls in value, the table below shows possible gains and losses.

If the price of the shareToYou could gain
Rises by 20%$6.00$3934.00
Rises by 10%$5.50$1937.00
Rises by 5%$5.25$938.50
If the price of the shareToYou could lose
Falls by 5%$4.75$1058.50
Falls by 10%$4.50$2057.00
Falls by 20%$4.00$4054.00

If the margin was lower than 5% the risk becomes even greater. In addition to any losses, this table doesn’t take into account any potential commissions, fees or interest the trader may need to pay.

  • CFDs are contracts

When trading CFDs, you’re buying a contract between you and the CFD provider. The contract outlines your speculations about the value of the financial product or underlying asset and is a legally binding agreement. Unless you have some trading knowledge and the time and patience to digest the provisions of the contract, you could get stung by a hidden clause.

  • The CFD provider may not act in your best interest

Not all CFD providers will act in the best interests of clients. This is referred to as counterparty risk. For example, there may be a delay between when you place a CFD order and when the provider executes it. This might mean your order is executed at a price which is worse, potentially costing you big dollars. If your trade is making a loss, your CFD provider could close out your trade at a loss without consulting you. The opposite is also true: you could implement a stop-loss order to try to protect yourself from losses, but the CFD provider may not honour this and might keep your trade open even longer. Because of these factors, the success of a CFD trade doesn’t just rely on your ability to make correct speculations and assumptions on the value movements of assets, but it’s also dependant on the CFD provider you use.

  • Your money might be held with other traders’ money

Every CFD provider has their own terms and conditions, but your money is generally covered by the law against a CFD provider misusing your funds. Some CFD providers may pool your money into one account mixed with money from other investors. They are then permitted by law to withdraw some of this money in the form of an initial margin and also a further margin if they need to. If your CFD provider withdraws this money it's no longer protected by the law as it's no longer in a client account and therefore counted as client money. If your money is pooled with other investors there’s an additional risk if one client fails to pay the money they owe in the event they lose a trade. This could delay your payments as the pooled account will be in deficit.

  • CFDs can be affected by market conditions

Because you’re speculating on the price movements of financial assets, such as shares, your trade will be affected by broader market conditions. However, because CFDs are highly leveraged, even a tiny dip in the market can result in not-so-tiny losses. Trading CFDs could become even more risky if you’re trading during times of economic uncertainty, such as major political elections. However even if the market is stable, there are often unpredictable, seemingly random events that affect the price movements of various financial products, making it almost impossible to predict for even the most experienced traders.

  • CFDs can move quickly

This is called ‘gapping’ and refers to the idea that a CFD can move in price between, for example, $5.50 and $6.00 without stopping at any of the price points in between. Therefore, even if you’d planned to close a trade at $5.55, you might not get a choice. Because the prices move so quickly, this opens up traders to increased risk.

How to mitigate these risks when trading CFDs

CFDs are a high-risk strategy and this is reflected in the strong warnings regulatory bodies such as ASIC place on them. Most investment strategies have an element of risk, and it’s important to understand what they are and what you can do to mitigate these risks before you begin trading. Here’s some strategies to mitigate the risks of trading CFDs:

  • Do your research.

Like any investment, it’s important to do lots of research before you begin. The more you understand about the ins-and-outs of CFD trading and the risks involved, the better.

  • Select asset classes you have experience with.

It’s a good idea to trade CFDs with underlying assets you understand and have experience with. For example, if you have lots of experience with share trading and understand what factors affect share prices, you could consider trading shares CFDs to begin with.

  • Start small.

It can be tempting to go big when you first get started, but remember when trading with leverage if you have the potential to gain a lot, you also have the potential to lose a lot. Trading in small sizes to begin with is a good way to get comfortable trading with leverage. It also means that if your trade doesn’t go as planned, you’ll only lose a small amount.

  • Open a free demo account.

Before committing your own money to a trade, why not take advantage of one of the free demo accounts offered by a number of CFD brokers on the market? IG Markets, CMC Markets and Pepperstone (to name a few) all offer demo accounts that allow you to practice executing trades in a simulated environment, providing you with an opportunity to test strategies and learn the mechanics of trading without risking any of your own capital. They even provide you with a small stipend of virtual funds to practice with.

  • Use stops and limits.

Tools such as stop losses and limit orders are a great way to minimise your risk, as they effectively allow you to cap your losses at a certain amount. These tools are a good way to protect traders against sudden or unexpected market movements, and are offered by most CFD trading providers.

  • Understand what you can afford to lose.

As CFDs are highly leveraged products, you can lose a lot more than your initial capital used to place the trade. It’s important to understand how much money you can comfortably afford to lose, so in the event that your trade doesn’t go well, you’re not losing more than you can afford. If you have done plenty of research and have extensive trading experience, you can compare CFD providers in our table below. If you want to learn more about CFDs, read our guide: What are CFDs?

Compare CFD providers

Updated May 24th, 2018
Name Product Minimum Opening Deposit Major Trading Instruments Commission (ASX 200 Shares) Platforms Name
$0
Indices, FX, Shares, Commodities, Cryptocurrency, ETPs
0.10% with $8 minimum
MetaTrader 4
ProReal Time
Trade from over 10,000 markets with Australia's leading service for CFD trading and forex. Introductory offer: receive a reduced commission for the first two weeks.
AUD$3,000
Indices, FX, Shares, Commodities, ETFs
0.10% with $8 minimum
SaxoTraderGo
SaxoTrader
More than 9,000 CFDs including single stocks, stock indices and commodities
$0
Indices, FX, Shares, Commodities
0.07% with $5 minimum
MetaTrader 4
CloudTrade
Welcome bonus of up to $500 after your first month. T&C's apply.
Trade CFDs on local and international shares, forex and commodities.
$0
Indices, FX, Shares, Commodities, ETFs
0.12% with $10 minimum
Halifax Pro
Halifax Plus
Trade US and Australian shares, options, futures and CFDs with no registration fees. Trade 24/7 on your desktop, tablet or smartphone.
AU$100
Indices, FX, Shares, Commodities, Cryptocurrency, ETFs
No commission
Plus500 Web Trader
$30 welcome bonus available. T&C's apply.
Trade Australian and international CFDs on shares, forex, indices, commodities and more.
US$200
Indices, FX, Commodities, Cryptocurrency
No commission
MetaTrader 4
MetaTrader 5
cTrader
Trade stock indices on the global market, via Pepperstone's MetaTrader 4 and cTrader client terminals.

Compare up to 4 providers

Was this content helpful to you? No  Yes

Related Posts

Ask an Expert

You are about to post a question on finder.com.au:

  • Do not enter personal information (eg. surname, phone number, bank details) as your question will be made public
  • finder.com.au is a financial comparison and information service, not a bank or product provider
  • We cannot provide you with personal advice or recommendations
  • Your answer might already be waiting – check previous questions below to see if yours has already been asked

Finder only provides general advice and factual information, so consider your own circumstances, or seek advice before you decide to act on our content. By submitting a question, you're accepting our Terms and Conditions and Privacy Policy.
Ask a question
Go to site