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Risks Associated with Contracts for Differences

A contract for difference (“CFD”) is a financial contract that pays the differences in the settlement price between the open and closing trades. CFDs are complex, leveraged products that are not typical or suitable for an inexperienced trader because you can potentially lose all your investments in the blink of an eye.

CFDs enable investors to be exposed to the markets with a minimal margin (‘deposit’) of the total value of the trade. They allow investors to take advantage of prices moving up (by taking ‘long positions’) or prices moving down (by taking ‘short positions’) on underlying assets. There is no delivery of physical goods or securities.

CFDs have a high level of risk compared to other types of investments due to low industry regulation, potential lack of liquidity and the need to maintain an adequate margin due to leveraged losses. CFDs are limited in some countries and banned in others.

Some of the risks associated with CFD’s include:

Counterparty Risk

Counterparty risk is the uncertainty that an organisation contracted to provide an investment service but is not able to do so. With CFDs, the only asset being traded is the contract, exposing the trader to the provider’s other counterparties. If the provider is unable to meet obligations, the value of the underlying asset is no longer relevant. Because the CFD industry is not highly regulated, a broker’s credibility is usually based on reputation and longevity.

Market Risk

Market risk applies mainly to stocks and options and refers to the economic, technological, political, or legal conditions that may affect the value of an investment. CFDs are derivative assets that a trader uses to speculate on the movement of underlying assets. Unexpected market changes can result in quick changes and even small changes can have a big impact on returns.

Liquidity Risk

This risk comes from the uncertainties of being able to sell an investment quickly enough to minimise loss. Market changes can cause your contract to become illiquid.

Gapping

Gapping is a risk that arises as a result of market volatility. It occurs when the prices of products suddenly shift from one price to another, as a consequence of market volatility. This occurs outside of the trading space and may stem from corporate actions (stock splits, dividends, mergers and acquisitions, and rights issues) or other non-trading activities.

While stop-loss orders are available from many CFD providers to help mitigate risks, those CFD providers cannot guarantee you will not suffer any losses. Managing leverage responsibly takes discipline and an understanding of how to use it as an investment tool. 

If you do not have extensive experience and understanding of the product and of the risks associated with it, a high-risk tolerance, or sufficient time to manage your investment and cannot afford to lose money at times, you should take a step back and assess whether or not this type of investment is suitable for you. 

See related article Risks of Trading CFDs.

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