Contracts for difference (CFDs) are, to put it mildly, a very high-risk investment product. Because CFDs are inextricably linked to rate fluctuations, the danger of making a loss at any time is a peril that comes with the property.
Due to the leverage effect employed by CFD products, the possibility of making a loss many times higher than the initial margin (deposit) which you put down as collateral is very real. In the worst case, you as the investor may have to knock into your personal assets to cover losses.
Let’s look at an example to help you better understand the concept. When you, as an investor, open a new CFD position, you only put down a set percentage of the CFD’s total valuation as collateral. This deposit is known as the «margin» in trading jargon.
CFDs: leverage risks
Instead of buying, let’s say, 10,000 francs worth of shares outright, you can put down a 10 percent margin to buy those same 10,000 francs worth of shares. Using a leverage ratio of 10 to 1, you would only have to invest 1000 francs, in this case. The higher the leverage ratio, the less money you would have to pay down as a margin when you open the position.
Using a 10 to 1 leverage ratio lets you gain up to 10 times the value of your capital investment - but you can lose money just as easily. A regular stock trader would gain just 500 francs if the 10,000 francs worth of shares in this example were to go up by 5 percent. But A CFD trader investing just CHF 2000 francs would come off a lot better, taking home a 1000 franc profit with a much lower investment outlay, and all thanks to the leverage effect.
CFDs: the debt risk
As thrilling as the perspective of making real profits may seem, that dream can just as easily turn into a nightmare, should the leverage effect turn on you. Even a seemingly insignificant market loss can quickly decimate your capital outlay. But worst of all, if the loss overshoots your deposit, you will have to reach deep into your own pockets to make up the difference.
If for whatever reason, you keep CFD positions open overnight, or over the weekend, things can get pretty nasty. If rates were to fall in a big way during that time, your losses can be colossal. To help prevent you from taking too hard a rap, some banks provide a service which automatically closes your positions when losses overshoot your margin.
CFDs: counterparty risk
In a regulated trading environment, the stock exchange plays the role of counterparty. The chances of a major stock exchange going bust are pretty slim, so the risk of your counterparty not living up to its side of the bargain is pretty small. But this risk becomes a lot more real when you participate in poorly regulated CFD trading. There are a host of smaller brokers which offer their services online. Unfortunately, there are always a few bad apples among them which don’t follow best practices and run a high risk of bankruptcy.
In the worst-case scenario, a broker’s bankruptcy could result in your losing the entire amount of CFD investment capital invested with them. That’s why it’s so important to do your research, carefully compare, and choose a reputable CFD broker before you make any investments.
CFDs: minimizing risk
Some banks and brokers offer an optional risk minimization option to investors who use their services. These limit investors to trading with low leverage ratios, but if things go south you will only lose the capital deposited in your margin.
Good CFD brokers also give you additional controls, including stop orders and limit orders. Limit orders let you select a price at which you want to buy or sell CFDs. Once this rate is met, the transaction happens automatically.
Stop orders work in much the same way, in that CFDs are also bought or sold as soon as prices match a preset rate you choose. The difference is that, unlike a limit order, the rate you set for a stop order is not guaranteed. Both of these services can help you to avoid major losses.