But aren’t CFDs more risky than Shares Trading?

Q:What are the Risks?

A: Like any leveraged derivative investment, there is always an element of risk when trading contracts for difference and it is important that you understand the key features of CFDs before you decide whether or not to risk your money. The gearing nature of CFDs may help to boost your profits if you correctly predict movements in share prices. However, the risk of loss also increases disproportionately if the stock’s price moves against you; in fact the main risk with a CFD is that the market moves against you and the leverage then magnifies the blow. For instance, a 10% price fluctuation on a CFD contract position with a 10% initial deposit would result in a loss equivalent to your margin deposit. Losses can exceed the funds you deposit into your account (although in practice you can cap losses through the use of stop loss orders).

Risks of trading CFDs -:

1. Investment risk: This is the risk that investment markets move against you, this is an inevitable risk when taking a trade although possibly mitigated with stop orders.
2. Liquidity, gapping and execution risks This is a risk with all trading products. Market conditions and the mechanics of trading might mean you cannot make trades when you would like to, or that your trades are not filled at the price you expect and thus your trades might be subject to slippage or gapping if there is unsufficient liquidity.
3. Counterparty risk: This is the risk that the CFD broker or another counterparty to a trade fails to fulfil their obligations to you. Trading CFDs exposes you not only to the risk of the CFD provider failing to act as contracted, but you could also lose money if other companies the provider deals with, or other clients, fail to meet their obligations. To mitigate this risk only deal with regulated CFD brokers whose shares are traded since these companies are obliged to publish any news that might affect their operations. It is also a good idea to spread your capital across different brokers. Some countries like the UK also provide an additional layer of protection. For instance in the UK, clients are covered by Financial Services Compensation Scheme (FSCS) in the unlikely circumstance that a CFD broker were to go into liquidation. In such a scenario investors receive the first £30,000 in full + 90% of the next £20,000. Maximum payout per client if the firm goes bankrupt is £48,000.

Q:But aren’t they more risky than shares trading?

A: Taking out a CFD on 10% margin for 1000 Next (LON: NXT) shares is equivalent to buying 1000 Next shares from a traditional broker. You plan a buy trade, and you can set the stop to equate to the loss you were prepared to incur if you bought the stock. If the trade goes the wrong way, your loss is the same whether a spread bet or non-leverage stock purchase.

In other words the risk is identical whether you buy 1000 Next shares or take out a contract for difference controlling 1000 Next shares. And this is where CFDs are unique in that you do not actually own the shares. Rather, you make a profit – or a loss for that matter – on the difference between the price at which you bought and the price at which you sold at the close of contract. The problems only occur if you overgear yourself and use your full margin capacity with making use of stop losses. For instance, if you open a CFD position with 3% initial margin and the market moves against your position by just 3%, this would potentially erase all your available funds and you may then even need to deposit more funds to compensate for the shortfall. Of course this can’t happen when trading shares directly but then you don’t get the benefits of gearing either.

Gearing is widely used in trading and stock investing: futures, options, warrants, contracts for difference, and the mother of all – FOREX. Many newbies are attracted to the possibility of putting a small deposit and acquiring big exposure. For instance in forex trading normal leverage is 1:100, but you could find one with 1:200 and even 1:500 (albeit I would say that gearing yourself x500 is suicide). This is one of the reasons CFDs are so powerful – with the same amount of money that you can go and buy 1000 Next shares you can gear yourself up and maximise profits.

CFDs, Futures and Foreign Exchange trading is high risk, trading on leverage means that any profits are magnified relative to your margin, this also works the other way and losses can quickly spiral out of control if not correctly mitigated. It is important that clients have a good understanding of leverage and how the margin account works, and have experience of trading the markets.

That’s where it comes down to how the instruments are used – if they’re used responsibly it is identical to buying shares. The big difference here is that you can also short them i.e. basically profit if Next shares decline in value. These are the circumstances in which contracts for difference can be such powerful instruments – because you can make money on a falling market. Even better you can use CFDs to hedge your portfolio of shares so in a falling market your losses are mitigated – people who had short index positions as hedging instruments have actually done quite well out of this market, better than those people who only had a long only portfolio.

It is however important to recognise that margin trading carries inherent risks and you need to manage this risk by taking volatility into account and using sensible risk management. CFDs aren’t suitable for laid back investors who want to buy and forget; they require hands-on attention and the preparation to be able to take decisions quickly. I wouldn’t recommend anyone who is starting out to gear himself/herself beyond 1:3 for the first year or two of trading. Gear yourself too aggressively and it is like pointing a gun to your head as the higher the leverage, the faster money disappears in front of your eyes if a position moves against you. On the other hand use gearing responsibly and you stand to reap the benefits.

For stock market traders that do understand the workings of CFDs and learn to minimise the associated risks, there can be substantial benefits. Through the utilisation of leverage and the convenience of online trading, short-term traders now have greater opportunities than at any time in the past.

Q:But do I have the control?

A: You are in control of the leverage used in your trading account and don’t need to use the full leverage that brokers make available to you. In fact, if you so wanted you could treat your CFD trading account like a conventional share dealing account and only limit your exposure to what you would invest in a normal trading account. So for instance, if you have $20,000 cash in your CFD account you could always take positions equaling no more than $20,000 in market exposure. This would equal zero leverage and represents no more risk than a standard share dealing account. This, coupled with sensible stop losses is a good way to gain some experience while minimizing risks.

Q:But how can you lose more than is in your account?

A: It is easy to lose more than your CFD trading account in theory. This is how it works -:

If you only have to put up 5% margin upfront and you use up all the funds in your account, then if the share moves more than 5% overnight then you will be wiped out. Anything past that and you are in the red. Imagine a situation where it moves 15% or more you are now in the red for twice what you had in the account yesterday. 😆

Using leverage sensibly is imperative. You do want to control positions that are larger than your capital base but you have to do this with prudence. The key is how much is at risk.

It is a flawed argument to argue whether CFDs are risky or not risky. CFDs are simply a tool which investors can use to improve their returns and manage their risk in the stock markets. A lot of investors suffer with CFDs because margin is used. If you take on too much margin (risk) then even small moves in the underlying can cause serious problems.

Q:Aren’t the odds against you? The house always wins in the end…

A: With Direct Market Access trading you can’t say that the house wins because you are not betting or trading against the house. You are participating in a real market with real buyers and sellers. The odds are not really against you as they are with a spread betting company or any other over-the-counter outfit who can artificially manipulate spreads and execution. But then again, in the end, it is essentially a skill game. And in case of Direct Market Access, the house wants you to trade more because they don’t earn by doing tricks to get your capital. Instead they earn from commissions.