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.
CFD trading carries a high level of risk and may not be suitable for all investors. CFDs are highly leveraged over-the-counter derivatives. You can lose more than your initial deposit and your potential losses may be unlimited.
As with any products that involve the financial markets CFDs are inherently risky. CFD trading is leveraged so whilst it can lead to greater returns on smaller deposits, it is also possible to lose more than your deposit. While stop losses can be allocated to each trade, they may not be guaranteed and will not always be filled at the level you requested in volatile markets due to market gapping or slippage. Investors should also look at the price of commission as many CFD providers have a commission charge.
CFDs are not suitable for everyone. Our message to investors is this: if you don’t understand contracts for differences, then do not invest!
No one can guarantee the performance of any financial product. You can lose all of or more than the money you put in if something goes wrong.
You are taking a considerable risk if you put all your money into one type of investment (for example, trading CFDs). Spreading your money between different types of investments reduces the risk of losing everything.
This educational material does not constitute financial product advice and does not take into account your investment objectives, financial situation or particular needs.
Trading carries a high risk and you should never trade with money you can’t afford to lose. The contents of this CFD trading guide are for educational purposes and should not be considered in any way as investment advice. Ultimately the trader must take responsibility for your own trading decisions.