CFDs: Their Risks & How to Avoid Them

CFDs: Luck or Rationality?

Contracts for difference or CFDs are derivative tools that allow you to gain profits from price fluctuations. If you predict correctly whether the price of a certain commodity goes up or down, the money is yours.

It makes CFD trading online similar to betting. However, when placing a bet on a horse or a greyhound, you trust your money to Lady Fortune. With CFDs, your main allies must be analysis, logic, and knowledge of markets.

So, what are the main risks of trading CFDs? What should you be aware of before investing your capital in this market?

 

Risky Business

Risks of CFDs are closely related to their advantages: it’s almost like the light and dark sides of the moon. Let’s observe each type of risk individually.

1. Failed obligations

What attracts more investors to this market each month is that you can enter the CFD game easily. Your initial investment can be as small as $50. Yet, you can make much more if your prediction is correct: 50%, 100%, or even 200% profits. How is it possible?

The trick is that you don’t directly invest in physical commodities like oil, gold, or wheat. Therefore, you’re free from a bunch of extra commissions: storage fee, and so forth.

By their nature, contracts for difference are basically futures contracts. Smart terminology aside, the payout that you will potentially receive comes from the money that other participants of the CFD market provide. We can call them counterparties.

So, when you invest in a CFD, this contract is your only asset. And here comes the worst part. Even if your prediction is correct, you might not see the money because other participants of the contract — your counterparties — might fail to pay what they owe your broker and you.

 

1. Pooled account

In some countries where CFDs are legal — in the UK, Singapore, and South Africa — there are special laws that protect your money when you buy such a contract.

These laws stipulate that your capital must be kept apart from the broker’s money. It helps to avoid the risk of hedging. Hedging is a strategy that is similar to insurance, which a broker can employ to protect their own investments using your funds. 

However, laws might not stop your broker from creating a pooled account. That means your money willна другую статью  be put together with other clients’ funds. From this account, your broker will draw margins, which, in the long run, can decrease your potential profits. 

 

1. Volatility

Volatility is a blessing and a curse at the same time. The entire CFD market mechanisms are based on it. It can lead you either to fantastic profits or dramatic losses.

Even if you’re highly experienced, and your guts tell you that the cocoa bean price will skyrocket during the next two weeks before Christmas, the market can ruin your hopes.

A sudden corporate announcement, natural disaster, sporadic local crisis, a breach in logistics, employees going on a strike — any surprise event can make your contract for difference reach the stars or nose down like a wounded bird.

 

1. Liquidity

Although CFDs are quite popular, sometimes there aren’t enough participants in a given market. It means there is simply not enough money. If that happens, your CFD will become illiquid. 

In this case, your broker will be forced to:

1. Request more margin payments,
2. Sell the contract at a price much lower to cover your expenses, let alone generate any profits.

Then another threat called “gapping” might occur. Gapping happens if the price of your contract for difference suddenly decreases before you can close the trade. So, to minimize the risks, your broker has to agree on much lower profits than you’d expect.

 

1. Leverage

Profits that are much higher than a small initial investment wouldn’t be possible without the leverage — the capital that you basically borrow from other participants or a broker.

The higher the leverage, the more you will earn. But if your prognosis is wrong, you will also owe more money than you’ve invested. A similar situation was observed among Russian traders in the spring of 2020 when oil futures put them into massive debt. 

 

Tackling the Risks

So, are there any methods to prevent CFD-related calamities? Actually, over the years of experience, CFD traders have come up with a few strategies.

 

1. Stop loss

Stop loss is simple and yet extremely effective. Basically, it’s like a protocol that serves to minimize your financial losses.

Your provider should offer the stop-loss order. Basically, it’s a fixed price that serves as a safety threshold. Once the CFD hits this threshold, the contract will automatically close, cutting off more potential losses.

 

1. Reputable broker

You must know whom you’re doing business with. Before you trust your capital to the brokerage firm, check their:

• License.
• Reputation.
• Easiness of depositing/withdrawing funds.
• History and level of professional expertise.
• Which country’s laws they are in compliance with, etc.

Choosing a trustworthy broker is half the battle won, actually. A definite plus if they offer a demo account where you can try investing using virtual money, learn the basics, and sharpen your skills.

 

1. Knowledge

It’s important to know and understand markets where you’re planning to buy CFDs. Your #1 allies here are Fundamental and Technical Analysis.

Fundamental analysis allows you to see the picture as a whole: the nuances of a given market, the news and announcements related to it, demand and supply issues, and so on.

Technical analysis is automated and checks the historic graphs for a certain commodity for you to make a prognosis.

 

1. Diversification

It’s best to expand your portfolio and never invest in just a single commodity, especially when it comes to CFDs.

If some assets don’t grow/decrease in price as you’ve expected to, others will. Again, it’s best to consult your broker on diversification, as they constantly monitor the market and know the most promising niches.

 

Risky but Profitable

With a proper understanding of the specifics, contracts for difference can let you gain profits from price changes. Follow our tips and minimize your risks while trading CFDs. Be analytical, never stop learning how the market works, and opportunities won’t wait to come.