In finance, contracts for differences (CFDs) – arrangements made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities – are categorized as leveraged products. This means that with a small initial investment, there is potential for returns equivalent to that of the underlying market or asset. Instinctively, this would be an obvious investment for any trader. Unfortunately, margin trades can not only magnify profits but losses as well.
The apparent advantages of CFD trading often mask the associated risks. Types of risk that are often overlooked are counterparty risk, market risk, client money risk, and liquidity risk.
- A contract for differences (CFD) allows a trader to exchange the difference in the value of a financial product between the time the contract opens and closes without owning the actual underlying security.
- CFDs are attractive to day traders who can use leverage to trade assets that are more costly to buy and sell.
- CFDs can be quite risky due to low industry regulation, potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses.
The counterparty is the company which provides the asset in a financial transaction. When buying or selling a CFD, the only asset being traded is the contract issued by the CFD provider. This exposes the trader to the provider's other counterparties, including other clients the CFD provider conducts business with. The associated risk is that the counterparty fails to fulfill its financial obligations.
If the provider is unable to meet these obligations, then the value of the underlying asset is no longer relevant. It is important to recognize that the CFD industry is not highly regulated and the broker's credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it's important to investigate a broker's background before opening an account. In fact, American customers are forbidden from trading CFDs under current U.S. regulations.
Contract for differences are derivative assets that a trader uses to speculate on the movement of underlying assets, like stock. If one believes the underlying asset will rise, the investor will choose a long position. Conversely, investors will chose a short position if they believe the value of the asset will fall. You hope that the value of the underlying asset will move in the direction most favorable to you. In reality, even the most educated investors can be proven wrong.
Unexpected information, changes in market conditions and government policy can result in quick changes. Due to the nature of CFDs, small changes may have a big impact on returns. An unfavorable effect on the value of the underlying asset may cause the provider to demand a second margin payment. If margin calls can’t be met, the provider may close your position or you may have to sell at a loss.
Client Money Risk
In countries where CFDs are legal, there are client money protection laws to protect the investor from potentially harmful practices of CFD providers. By law, money transferred to the CFD provider must be segregated from the provider’s money in order to prevent providers from hedging their own investments. However, the law may not prohibit the client’s money from being pooled into one or more accounts.
When a contract is agreed upon, the provider withdraws an initial margin and has the right to request further margins from the pooled account. If the other clients in the pooled account fail to meet margin calls, the CFD provider has the right to draft from the pooled account with potential to affect returns.
Liquidity Risks and Gapping
Market conditions effect many financial transactions and may increase the risk of losses. When there are not enough trades being made in the market for an underlying asset, your existing contract can become illiquid. At this point, a CFD provider can require additional margin payments or close contracts at inferior prices.
Due to the fast-moving nature of financial markets, the price of a CFD can fall before your trade can be executed at a previously agreed-upon price, also known as gapping. This means the holder of an existing contract would be required to take less than optimal profits or cover any losses incurred by the CFD provider.
The Bottom Line
When trading CFDs, stop-loss orders can help mitigate the apparent risks. A guaranteed stop loss order, offered by some CFD providers, is a pre-determined price that, when met, automatically closes the contract.
Even so, even with a small initial fee and potential for large returns, CFD trading can result in illiquid assets and severe losses. When thinking about partaking in one of these types of investments, it is important to assess the risks associated with leveraged products. The resulting losses can often be greater than initially expected.