CFD trading is a contract between the two parties. It allows investors to bet on a stock price, a currency pair, or a stock index. CFD s are derivative products, traded over the counter OTC. With an over the counter contract, both parties are taking risks. If an investor fails, it can be to all the other clients with that derivative provider. Let’s see the main risks of trading CFD that you could be exposed to.
Counterparty risks when trading CFDs
A counterparty is an entity or company on the other side of a money transaction. When you buy or sell a CFD, the broker who issues the contract acts as your counterparty. A contract for the difference must, therefore, be closed with the counterparty that issued the contract. The trader is also exposed to a risk from the CFD provider counterpart, such as other clients and the various brokerage firms used by the broker to hedge trades.
Risks of improper money management
Other risks of trading CFD are related to your choice of a broker and risk management. Statistics say that around 80% of retail investor accounts lose money on CFDs.
You shouldn’t go for a broker who does not hedge his positions effectively. When potential dangers translate into real problems, investors cannot transfer their over-the-counter derivatives to other counterparties. Even in favorable market conditions, improper risk management can cause a CFD broker’s difficulties.
CFDs are the financial instruments that require responsible risk management by the CFD provider. The nature of the over-the-counter market and the fact that there are no real underlying asset results in counterparty risk. Trading is already difficult, so traders should choose a CFD broker who is in good financial standing to minimize counterparty risk.
How to choose a reliable CFD broker
CFDs brokers must be selected carefully. The trader who wants to open a CFD account should take the time to ask questions about the broker. It is possible to reduce the counterparty risk by choosing a broker who does not bear the risk entirely on itself. It’s a CFD broker that offers Direct Market Access (DMA) and allows traders to trade directly on the electronic stock market. One possible downside with DMA trading is that you won’t always get guaranteed stop losses for free.
The risk of to much leverage
With leverage, you have access to the market by depositing only a certain percentage of the trade’s entire value. Due to the leverage and according to the market movements, you can lose significant amounts in case of a lack of risk management.
If you buy an amount of € 2,000 in CFDs and the applicable margin rate is 5%, you will only need to deposit your position margin of € 100. However, your exposure is the same as if you had bought the equivalent of $ 2,000 in physical shares directly. This means that any market movement could significantly affect your capital than if you had bought the same value in shares.
The risk of additional fees
The risks of trading CFD are also linked to fees and costs. Depending on the positions and the length of time you hold it, you may incur additional financing fees and costs. These fees apply to your account daily if you hold positions in certain products beyond 5:00 p.m. New York time. In some cases, especially if you are holding positions for a long time, the sum of these financing costs could exceed the number of profits made or could potentially magnify the number of losses. Make sure you have sufficient money on your trading account to cover all incurring fees and costs.
Final Thoughts
The CFD market is booming in recent years, becoming an investment of choice for many traders. CFD brokers represent some sort of medium between the financial market and retail investors and traders. As such, they should be aiming to make profits from both the clients and the market itself. By encouraging their clients to make successful trades, the brokers generate more profits in the long run. To prevent the clients from running into too risky trades, the good broker will offer within its service the proper financial advice and risk management of the client’s account. Generally, as any other trade, CFD brings the risks we mentioned above. But, you are not unpowerful towards that. If you make an effort to get a proper CFD trading and make sure your capital is within the right hands and managed by the right brokers, the adversities can be avoided.