Risks associated with trading CFDs

Risk in the trading sense refers to the possibility of losing money in the market place (i.e. market exposure).

As with any form of investment, there are a number of risk factors that will impact on how well your portfolio performs over a period of time. Some of these factors relate to the company or its industry you are investing in or trading, while others are more broadly based. If you are not willing to take on any risk leave your money in the bank and even that isn’t an iron-clad guarantee!

A leveraged investment in derivatives carries a higher degree of risk to the investor, and due to fluctuations in value you may not get back the amount you invested. With certain transactions you may not only lose what you invested at the outset but may lose more than you invested depending on the amount of leverage you have taken. Only those who have experience in trading the stockmarket should consider trading CFDs

Click here for more information on the general risks associated with investing or trading in the stock market. The geared nature of CFDs also means that CFD trading can carry greater risks than conventional share trading.

Take a look at some of our HomeTrader clients who have achieved over 200%^ return trading CFDs and read about some of their trading experiences.

Don’t know what a CFD is? Click here for a detailed explanation or attend HomeTrader’s FREE Intro Seminar.

Underlying Asset Risk

A consequence of volatility and illiquidity in the underlying asset can be "price gapping" where price fails to move in regular increments.

If this occurs you may experience slippage, where you receive an inferior execution price on your stop orders than your designated level. Subsequently you may incur losses greater than you anticipated and greater than your account balance if you are using leverage.

A trading halt or suspension of the underlying instrument will also affect your ability to deal in the CFD.

Shorting Risk

When using CFDs to short-sell your potential risk can be much greater than the face value of the transaction.

Shorting a position involves taking on a contingent liability where to close the position you must buy back the CFDs and you will be liable for any loss resulting from an upward move in the price. This loss can potentially be unlimited as theoretically a share price could rise to infinity. This differs from a long position where your loss is limited to the initial face value of the transaction.

For example, if you short-sell 10,000 CFDs at a price of $1.00 and your face value exposure is $10,000. If price rises to $2.00 your loss will be $10,000 (equal to the face value of the position). If price rises to $3.00 your loss will be $20,000 (greater than the initial face value of the position). As the price continues to rise your loss exposure will also rise and is unlimited.

Click here for more information on the mechanics of short selling.

Leverage Risk

CFDs provide the ability to use leverage which magnifies your exposure to the market. For a small initial margin payment you can open a position of a greater value. A relatively small market movement can lead to a proportionately much larger movement in the value of your investment and this can work against you as well as in your favour.

 

For example, on a $10,000 position the leveraged risk vs. return profile is shown in the below table:

 

Profit/Loss as % of initial outlay:		Long Position		Short Position
Margin Rate	Margin Required	Loss of $500 if price falls 5%	Profit of $1,000 if price rises 10%	Profit of $500 if price falls 5%	Loss of $1,000 if price rises 10%
10%	$1,000	-50%	+100%	+50%	-100%
5%	$500	-100%	+200%	+100%	-200%
3%	$300	-167%	+333%	+167%	-333%
1%	$100	-500%	+1000%	+500%	-1000%

 

Counterparty Risk

CFDs are a derivative product traded both over-the-counter or OTC or on exchange (ASX). CFDs traded OTC might be considered to involve greater risk than exchange-traded derivatives as there is no exchange market on which to close out or open the position only directly with the CFD provider.

The CFD provider is the issuer of the CFD, therefore you are exposed to the financial and business risks associated with dealing directly with a company. This includes the risk of loss in the event of the CFD provider’s liquidation.

Under the Corporations Act the CFD provider must hold client money in a trust account which must be segregated from the CFD provider’s own funds.

In the event that the CFD provider became insolvent and there was a deficit in the trust account you will be an unsecured creditor for the balance of money owing to you. Also, in this event any open CFD positions would not be covered by the National Guarantee Fund as they are with shares.

Operational Risk

There is always operational risk in any trading transaction. For example, disruptions in operational processes such as communications, computers, networks, or external events may lead to delays in the execution and settlement of a transaction.

You may also experience loss due to your own trading errors for which you are fully responsible. To help minimise this risk you should ensure you pay attention to detail when placing, amending or cancelling orders.

Want to know more? Register here for HomeTrader’s FREE Intro Seminar.

Spread Risk

Because of the difference between the buying and selling price of a CFD, the relevant CFD price must move favourably before you break even. In other words, even if the CFD price does not move at all and you close out your position, you will make a loss to the extent of the spread and any charges and commissions which have been charged. Furthermore, the spread may be larger at the time you close out the position than it was at the time you opened it.

Margin Risk

You could lose all the margin funds you deposit with your CFD provider to establish or maintain a CFD position. Also, if the market moves against your position you may be required, at short notice, to deposit further moneys as margin in order to maintain your CFD position. If you fail to provide those additional funds within the required time your CFD position may be liquidated. You will be liable for any shortfall in your trading account resulting from that liquidation.

Market Volatility

Derivative markets can be highly volatile. The price of CFDs may fluctuate rapidly and over wide ranges and may reflect unforeseeable events or changes in conditions, none of which can be controlled by you. The price of CFDs will be influenced by, amongst other things, changing supply and demand relationships, governmental, agricultural, commercial and trade programs and policies, national and international political and economic events and the prevailing psychological characteristics of the relevant marketplace.

Liquidity

At other times the underlying market may lack liquidity because of insufficient trading activity or the aggregate of all requests for orders at a particular price or range of prices determined by the CFD provider exceeds that available in the instrument in the underlying market to which your request relates. This may affect the ability of the CFD provider to offer the relevant CFD in sufficient volume to allow you to close out your position or open a new position. Alternatively, some market makers may re-quote the price at which it offers the relevant CFD to you.

Security Suspension

Trading in the underlying market may be suspended or halted for a variety of reasons. This may also affect the ability of the CFD provider to offer the relevant CFD to allow you to place an order to close out your position or open a new position. As a result, a potentially profitable deal may not be executed, or it may not be possible to close out a position in a timely fashion at the price you want leading to reduced profits and higher losses. As a result part (or all) of your trading float may become inaccessible to you during the period of suspension.

 

^ Past performance is not a guarantee of future performance.