It is undeniable that stocks and CFDs can highly lucrative – but it is also a fact that they are inherently risky and that stock market trading can be a hazardous business. High rewards usually come with higher risks and the speculator has to balance the risks with the rewards and devise ways to contain the risks as much as possible. In this section we will address the main risks facing the CFD speculator; although you shouldn’t consider this list exhaustive by any means; risk comes in many manifestations and no one can prepare you for all of them. Experienced traders welcome these risks because these threats constitute opportunities to make money though boom or bust at the same time. When global economies are booming and companies doing well, CFD traders can profit as stock prices soar. Conversely, when risks are high and companies are struggling, CFD traders can gain by taking on short positions as share prices dive. We will now highlight the types of risk and how you can counteract them.
Systematic risk represents the hazards of a company operating within a system. Stock market traders are able to hedge against certain risks, but it is very difficult to predict systematic risk. A few of the more extreme examples of systematic risk (aka as Black Swan Events) are the Wall Street Crash in 1929, Black Monday in 1987 and the Asian Financial Crisis in 1997. The Black Swan Theory or ‘Theory of Black Swan Events’ was developed by Nassim Nicholas Taleb to explain 1) the disproportionate role of high-impact, hard to predict, and rare events that are beyond the realm of normal expectations in history. In such circumstances, all global markets are likely to fall and this can have far-reaching consequences. The ability of CFDs to be used as a hedging mechanism (short) is a useful riposte to this risk.
Warren Buffett – ‘In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen’. Be prepared for the ‘unknown unknowns’ i.e. events for which you are completely unprepared until they arrive out of the blue. Given that it’s impossible to find out the frequency and severity of these hazards, you should always assume the worst and trade in a state of acute caution.
These are the direct risks that are within control of a company and are generally avoidable; it represents the underlying hazard associated with being invested in a particular share or CFD. Many factors can affect a company’s performance and since these risks are related to the performance of particular companies as opposed to the whole market, they are referred to as unsystematic risks. These could include profit warnings, lawsuits, fraud, employee strikes, protests or controversy against the company..etc Any of these risks can cause a company’s shares to fall. You can reduce your exposure to unsystematic risk by diversification i.e. investing in separate companies in different industry sectors and markets.
This represents the risk that a company becomes insolvent and defaults on its debts or has its credit rating cut by analysts making it more likely to default. This is a real risk, especially when investing in small caps or start-ups; the company may have been insufficiently capitalised in the first place or hit by economic turmoil, fraud, or due to anything from a fundamentally poor company performance to bad bookkeeping. If a company becomes insolvent and is unable to repay debts to banks or the bond holders it loses the ability to function properly – and share (and CFD holders) while not directly affected by the loan repayments, will be seriously affected as the share price of the company dives since the company is technically insolvent.
This risk is present whenever investors buy and hold investments in currencies other than their native currency. Much like shares, currencies move up or down and if an investor located in, say, the UK buys shares into a USA company that reports its profits in dollars, and the USA dollar strengthens against the pound, then the investment will gain from the favourable exchange rate. Unfortunately, this also works in reverse and if the foreign currency in which that investment is held loses value against the investor’s native currency, then the investment will suffer from the unfavourable exchange rate. Let’s take the case of a British investor who buys a USA stock for $80 when the exchange rate between the pound sterling vs the USA dollar is 1.6000. So each £1 is worth $1.60. The British investor would thus have to pay £50 for the $80 stock ($80/1.6000). In the next few months the stock rises by 25%, rising from $80 to $100 ($20 gain). At the same time, the British pound gains against the USA dollar so the £1 now buys $2.10 (as opposed to $1.60). So the share has made a $20 gain but the bad news is that the $100 it is now worth only translates to just £47.62 ($100/2.10) if the investor decides to sell his share and swap back for pounds.
Interest Rate Risk
One of the biggest influences that drives global and local economies are interest rate changes made by central banks such as the Bank of England, the USA Federal Reserve and the European Central Bank. Such decisions can possess the power to move the markets immediately and with full force. In a general sense rate hikes make it more expensive for companies to borrow in order to keep expanding. This makes their outlook less attractive and tends to undermine equity values. Conversely, interest rates cut makes it cheaper for companies to borrow to expand and this tends to have a positive effect on share prices.
Politics and business don’t always mix together and political risk refers to the hazard you are exposed to should the political or economic conditions in the country where an enterprise operates change becoming less transmissive to business growth. This can take several forms like increased taxation (example: VAT increase) or tariffs that cut on a company’s profit margins. At worst, this could involve a business being nationalised, losing shareholders most or all of their investments like what happened to Northern Rock plc (bank) in the United Kingdom during the credit crisis. These kind of risks are likely to undermine share prices. So, always consider the impact of forthcoming or future legislation, particularly if you tend to prefer to invest in companies which operate on the fringe of markets or in a ‘Wild West’ environment.