Trading Contracts for Difference (CFD) can have a high risk of loss as well as potential for profits regardless of how the market is going.
A CFD is a leveraged derivative which allows you to trade on whether the price of a financial instrument will go down or up.
How does it work?
A CFD is in essence a bet on whether an underlying asset such as a share, commodity or foreign exchange will rise or fall. You invest a fraction of the market value of the share, which can be between 1% of 15%. The remainder is covered by the CFD provider.
Even though you only pay a small percentage of the instrument's value, you can still realise the profits and losses you'd make if you owned the instrument completely.
This means both profits and losses can be magnified greatly depending on what happens to the value of the shares.
Remember to really ask yourself:
Before getting into the wonderful world of CFD’s, you must ask yourself if the money you invest will run you into financial ruin if you lost it all. No matter what size the investment if the answer is yes, CFD’s and trading in general probably is not for you.
The risks of CFD trading
You can lose more than your initial deposit - The main reason why CFD trading is so risky is because of the margins involved. You stand to make large profits but also large losses.
The table below is courtesy of ASIC's Moneysmart website and shows the potential loss you could make.
The example below assumes an investor bought 4,000 CFD orders at $5 per order for a total of $20,000. The CFD has a 5% margin, meaning the investor only pays $1,000, in addition to a 0.15% commission charge equalling $30.
If the price rises or falls, the table below shows the possible gains or losses.
If the price of the share:
You would gain or lose
This would be a return of
Rises by 20%
Rises by 10%
Rises by 5%
Rises by 2%
Stays the same
Falls by 2%
Falls by 5%
Falls by 10%
Falls by 20%
This example assumes the investor closes the trade at the indicated price. It doesn't include other fees, charges or interest.
As can be seen, the investor could lose much more than they originally invested if the underlying asset falls by even 5%. This is the great risk of CFD trading.
The higher the leverage (in other words the lower the margin) the bigger the risk - a small margin means even small movements in the market can have a big impact on the success of your trades
Every CFD provider has their own terms and conditions - 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.
An additional risk if your money is pooled with other investors might occur 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.
It's very hard to assess the risks involved with a CFD provider - A CFD provider may not fulfill their obligations to you, or other connected parties might not fulfil their obligations to the CFD provider, meaning you could lose money or have to wait to access it.
If a CFD provider has financial difficulties they may not meet their obligations to you. This could be especially present if the CFD provider deals with a primary client who has financial difficulties, which could lead to the aforementioned delays or loss of money.
Market conditions may contribute to your losses - Market conditions contribute to the profits or losses of any trade, but they can affect CFDs in a number of unique ways. These include:
- Liquidity - If there's a lack of trades made in a market for a particular underlying asset, the CFD provider may decline to carry out your trades or only offer a less-than-ideal price.
- Gapping - CFDs can also move quickly on the market and may skip price points, meaning you can't sell when you wanted to. Even stop-loss orders might not be able to eliminate this risk, as the CFD may not execute your stop-loss at the price you've agreed to. You may be able to set a guaranteed stop-loss, but this will come with a higher price.
- Execution risk - There may also 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.
Some CFD Providers may demand you put in more money at short notice, called a 'margin call', to keep trading. Failure to do so may make you have to sell at a loss or mean the CFD provider closes your trades without consulting you.
Types of CFDs
These are the types of CFDs which you can trade.
Over the counter (OTC) CFDs
These refer to CFDs which are purchased directly from a CFD. This means you enter an agreement with the CFD provider and will be partial to their unique terms and conditions, some of the risks of which are listed above. The two types of CFDs include:
- Market maker - The CFD provider comes up with their own price for the underlying asset which the CFD is being traded for.
- Direct market access - The price of the CFD is dictated by the market for the underlying asset.
ASX exchange-traded CFDs
This refers to a CFD which you buy through an approved broker. This type of CFD is listed on the ASX and reduces some of the risks mentioned in the section above.
Minimising the risk of a CFD trade
Buying an ASX exchange-traded CFD can decrease some of the risks of investing a CFD, but can never mitigate the risk completely.
Stop-loss orders may also mitigate some of the risk of CFDs, although as mentioned above, unless these are guaranteed they may not be executed.
There are a few questions you can ask to avoid some of the pitfalls associated with a CFD, especially if it’s an OTC CFD.
- Ask what type of CFD you’re buying and whether it’s a market maker or direct market access type if applicable.
- Ask them if they meet the seven disclosure benchmarks set by ASIC. If the answer is no, ask why.
- How your money will be handled and if it will be pooled with other clients.
- What will happen to your money in the event the provider or another primary client runs into financial difficulty.
- What fees and charges you may pay.
Most investment strategies have an element of risk. CFDs are a high risk strategy and this is reflected in the strong warnings ASIC places on them. If you feel CFDs might be an appealing way to earn profits with minimal outlay, please consult your financial advisor or other professionals to obtain proper advice.