CFDs: Disadvantages and Pitfalls


Q.: What are the disadvantages of trading CFDs?

A: There are some disadvantages to trading CFDs, many of which are based on the fact that CFDs are mostly over-the-counter (OTC) derivatives [unless they are exchange-traded CFDs] which implies that your broker is the counter-party to your contract as per their terms and conditions of use which are usually written to benefit the CFD provider:

You are only required to deposit a percentage of the value, instead of having to deposit the entire value of your position size. Using contracts for difference, for a deposit, typically 10 per cent for liquid stocks, investors can purchase full exposure to a stock, including dividends. The same key advantage of trading cfds (i.e. trading with margin) can cripple you if you aren't careful. If you've put £100,000 in, you've effectively got £1 million worth of the stock. If a £10 share moves to £11 you will have doubled your money. If it goes to £9 you have basically wiped yourself out and you may receive a margin call from your broker demanding more money if you had bought into the stock thinking it would go up and it went down.

 

For this reason speculators using a CFD product need to be very careful, depending on their gearing, as one can make use of different levels of gearing (i.e. leverage). You don't need to borrow 100% of your house - you can borrow 50% or you could borrow 75% and likewise with CFDs you can gear to different levels. It is crucial to have appropriate stop-losses in place (usually as a percentage move in the underlying share price against the trade) to avoid the possibility of any margin calls and to manage your risk.

Another downside is that you are liable to pay interest on the total transaction amount, regardless of the amount of margin that you have contributed.

Lastly, as an OTC derivative you may not be offered the same protection as when you purchase shares through the traditional route of using a broker. For instance, some CFD providers are not obliged to use the stop losses you specify, or may also 'bundle' together orders from other traders and give you an average price.

In a nutshell -:

1. Price requotes and crossing the price spread with Market Makers CFD providers.

2. Leverage can be a double-edged sword - it is essential to apply appropriate money-management techniques.

3. Easy of access and low capital requirement can lead to over-trading.

4. Long trades held of extended lengths of time attract ever-increasing interest payments.

Q.: What are the most obvious pitfalls that traders need to be aware of?

A: CFD trading, especially during periods of market volatility, requires careful timing when opening and closing positions. For this reason alone, CFDs may be suitable for the active, experienced investor.

CFD as an instrument that offers geared exposure - profits can multiply during this process but remember - so can losses. This means that if you invest £1,000 in shares and they fall 10%, then you have lost £100. However, if you use that £1,000 as a deposit to back a CFD investment of £10,000, then a 10% fall will erase your entire capital. It is therefore very important to remain completely disciplined and focused, cutting losses quickly and without remorse. The sheer volatility in these markets makes experience vital. It is also a good idea to operate a stop-loss system. This ensures that your losses are limited to a pre-determined amount, normally 10% to 20% below the price you paid. If your positions hit this level then they will close automatically. If you do not operate a stop-loss system and your position deteriorates then one of two things can happen. You will either receive a margin call, which is normally in the guise of a phone call from your broker requesting more funds, or failing that your broker will close your position for you.

Lastly, if you find yourself closing positions out of 'fear' then your strategy is flawed and you are most likely over trading. With gearing, it is easy to panic when you see the market direction going the wrong way and close your position too early. I would say that one should never really gear up more than say double (maximum treble) the value of your equity. Whereas in reality it's easy to end up geared 4,5,6 or more times with cfd trading accounts. This is important as you need to leave headroom on the account for adverse price movements. because you can gear yourself ten times doesn't mean it's necessarily a clever thing to do - you need to assess the risk and potential downside of each trade properly.

Q.: What about CFD providers changing or re-quoting prices after I've already placed an order?

A: CFD providers (like any other broker for that matter) reserve the right to re-quote prices to you after you have placed your order. This usually happens if there is insufficient liquidity in the markets or during very volatile market conditions where the prices changes between the moment you submit the quote and it being executed. While these CFD providers tend to offer a wider range of CFDs than other providers, re-quoting of prices by providers can affect the profitability of your trades.

Q.: Why should I be wary of using too much margin in trading?

A: Taking too much margin is a real killer. If you take on excess margin (risk) then even small moves in the stock or index you are invested in can cause serious problems. The City of London for instance is littered with excellent traders, ones that have made millions but then lost it all. They had the skill, knowledge, street smarts and whatever else you need but the margin got them in the end. Most of them bounce back though.

Remember when the IRA bombed the Brighton Hotel and nearly got Maggie? Afterwards they (IRA) said 'we didn't get her, but we only have to be lucky once, she has to be lucky all the time'.

And it's basically the same with margin, you only have to be unlucky once and it can kill you, or at least wipe 50% of your account out in a very short period of time and if that happens most people can't take it anymore.

Want a good real time example? A fellow called Mark Shooter of Shooter Fund Management. One of THE best options traders around, made a lot of money, was super smart... etc. But he's now busted out, lost £100's millions when volatility went throught the roof in the summer of 2007.

See, you only have to be unlucky the one time which is why 80%+ lose overtime. But as I said, if you use margin responsibly then the odds of success are pretty good, as long as you know what you're doing. But then humans are naturally greedy, why settle for 12% a year when with margin I could make 300%+!!


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