Contracts for differences are derivatives where investors bet on the price movements of an asset. The settlements are made through cash payments instead of through delivery of goods and securities. CFDs are also highly leveraged products. And investing in CFDs entails many inherent risks that should be controlled by the investor. The following are some of the biggest risks that CFD investors face.
The counterparty refers to the entity that provides the asset in a financial transaction. When you’re buying or selling a CFD, the asset that you’re trading is the contract that the CFD provider issues.
That means the trader is being exposed to the provider’s other counterparties, such as other clients that that CFD provider conducts business with.
The associated risk is that the counterparty fails to the meet its financial obligation. If the provider cannot meet the obligations, then the price or value of the underlying asset is no longer relevant.
CFDs are derivative assets that traders use to speculate on the movement of the underlying assets such as stock.
If one believes the underlying asset will rise, the investor will opt for a long position. On the flipside, investors will choose a short position is they estimate the price of the underlying asset to fall.
In actuality, even the most experienced investors can be wrong. Quick changes can arise from unexpected developments, changes in market conditions, government policy, and new information.
Because of the leveraged nature of CFDs, even a very small change may have huge impacts on returns. The provider may even demand a second margin payment because of such unfavorable change.
If you cannot meet the margin call, the provider may close your position and you may have to sell it at a loss.
Client Money Risks
Some countries do not allow CFDs trading. In the case of countries that do, there are client money protection laws that protect the investor from potentially harmful practices from CFDs providers.
According to the law, the money transferred to the CFD provider should be segregated from the provider’s money in order to prevent providers from hedging their own investments.
On the other hand, the law may not prohibit the client’s money from being pooled into one or more accounts.
When a contract is in place, 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 the margin calls, the CFD provider has the right to pull from the pooled account that has potential to affect returns.
Liquidity Risks and Gaps
Market conditions impact many financial transactions and may add to the risks of losses. When there are not enough trades being made in the market for an underlying asset, the contract can become illiquid.
In this case, the CFD provider can require additional margin payments or close contracts at inferior prices. Because of the rapidly changing nature of the financial markets, the price of a CFD can fall even before your trade can be executed at the predetermined price.