What are the risks of trading with CFD?

[Paul Beck]

[Justin Freeman]

There is a long list of risks that apply to CFD trading. Some you might have already given thought to, some may be factors you initially overlooked. While the markets remain beyond anyone’s control the amount of time that you give to studying and understanding risk is something that you are directly in control of, so improve where you can. Regardless of the degree of familiarity you end up having of risk factors it is critical to remain aware of three things:

1. Each risk factor can single-handedly cause you significant losses and even wipe out your account. Given the nature of markets, it’s often the case that one risk event triggers another until they end up impacting your account in unison.
2. Some risk factors are unknown to you until they occur. An unexpected ‘Black Swan’ event is one that deviates beyond what is normally expected to happen.
3. Risk factors are ‘live’. Be aware of the ever-changing nature of each risk factor that threatens your CFD trading.

  Treating risk as a box-ticking exercise is easy but costly. Understanding, measurement and management of risk are addressed here and while understanding the below ‘list of risk’ is a useful place to start, it should be by no means the place you finish preparing to trade CFDs.

Market risk

Market moves against you are a simple enough principle to understand. In CFD trading any losses are magnified due to the use of leverage. Short positions deserve particular mention as a Short Sell can hypothetically incur unlimited losses. Whilst the price of a long CFD can go no lower than zero the price of a short can just keep going up.

Margin Call risk

Trading CFDs involves the putting up of margin and significant losses on your account can eat into this ‘deposit’ pretty quickly. Whether it’s one bad position or losses across your whole CFD portfolio, as the margin is eroded you are left running the risk of being ‘stopped out.’ That is where your positions are closed out by the broker because you do not have sufficient funds placed with them to cover possible trading losses.

Single name risk

Taking a large position in a particular instrument that then forms a significant percentage of your total trading capacity concentrates risk in that one CFD name. You would be subject to general Market Risk but also exposed to events specific to that instrument.

Operational risk

These are factors that might restrict your ability to trade. For example, what would happen if you couldn’t connect to the broker platform due to your own lack of connectivity or possibly more significantly if your broker platform itself went down?

Liquidity risk

Illiquid markets are subject to Gapping the major consequence of which is that you are unable to sell at a previously agreed upon price. Even Stop-Losses may not be honored unless the terms and conditions of your Guaranteed Stop Loss hold firm.

Counterparty risk

A CFD contract relies on both parties meeting their obligations. You will put up margin to cover price moves but your counterparty will not so should they not be able to meet their obligations you will not benefit from any favorable price moves.

Other risk

This intention of this ‘list of risk’ is to provide a framework upon which you can build a better understanding of the, known and unknown, risk factors that apply to your CFD trading.