Understanding the 4 Main Risks of CFDs

But what are the risks of CFDs...

• A Contract for Difference (CFD) is a financial derivative typically used for speculative day trading and potential short-term profits. They are often very highly leveraged and are not suitable for long-term investments.
• A CFD pays the difference between the price of an underlying asset (e.g., a share, commodity, FX rate or even options) at the opening and closing times of the contract.
• CFDs are leveraged instruments that can generate high returns but come at very high risk. The majority of traders lose money!
  

Risks of CFDs

1) Leveraged Position (Lost of Entire Investment and Possibly More)

With higher returns come higher risks. While trading on margin magnifies your earnings, it also magnifies your losses if the market swings the other way. You may lose your entire original investment and more! 

Example 

Let’s look at a more realistic scenario where you invest in the thousands. If your initial investment amount in CapitaLand CFDs is $10,000 and the leverage is 20:1, your position will open with an investment of $200,000 ($190,000 borrowed). The moment the CapitaLand Shares drop from $4 to $3.80, which is a 5% decrease, your entire initial investment will be wiped out!

2) Availability

Like options, CFDs are not available for every share, bond, or index you come across.

3) Counterparty Risk

CFDs are usually not traded on exchanges; they’re traded over-the-counter (OTC) with your brokerages. This means that the other party is actually your CFD broker, who could fail to fulfil their end of the contract (e.g. if you close your CFD position but your brokerage fails to pay you the difference that’s due). This inability to fulfil their financial obligation will void the value of your CFD. Hence, you must choose an appropriate brokerage with a strong financial standing and stellar reputation. 

Note that you cannot transfer your CFD over to another CFD brokerage! They are contracts between you and the brokerage you bought it from.

4) Transparency

As mentioned, there are two different prices: the bid and the ask. On exchanges, the bid and ask price are settled through demand and supply, i.e. the transactions taking place on the exchange. However, because over-the-counter transactions operate in a closed system, the brokerage firm decides the bid and ask prices for their CFDs, with reference to the market price of the underlying assets. As such, there may be a difference. 

Typically, brokerage firms will try to remain competitive and follow the market price as closely as possible. Still, when the market faces high volatility and prices constantly fluctuate, the bid-ask spread may widen and deviate from the market prices. As we know, the bid-ask spread acts as a brokerage fee, so a widening spread is not favourable to investors.

Daily Leverage Certificates (DLC)

DLCs may be a way to mitigate the two risks shown above that stem from over-the-counter transactions. So what are DLCs?

• DLCs track the price changes of an underlying asset and the payout will be the difference between the prices at the opening and closing times on the contract (within a trading day)
  
• DLCs are leveraged instruments, meaning that you only need to fork out a percentage of the initial contract position
  
• DLCs have both long and short positions available for investors
• DLCs are traded on exchanges

Sounds familiar? You can think of DLCs as the exchange-traded versions of CFDs! As they are traded on the exchange, it reduces counterparty risks and price transparency. However, trading on exchanges has its drawbacks: products are all standardised, so there will be no room for customisation, fixed trading hours, and your product range may be limited to what’s already available. 

In Singapore, you have ready access to both CFDs and DLCs, so decide which of the two is more suited for your investment objectives.

Conclusion

CFDs are advanced financial products that require a good understanding of risk and return. If you are new to investing, we advise you to give our articles on basic investing a read first and get some experience on the basic markets before moving on. If you’re already ready to tackle CFDs, do your due diligence and research the products that you’re eyeing. Financial derivatives can open a world of wonders for your portfolio. Still, it is important to always keep the risks in mind, which, especially in the case of CFDs, may be very substantial.

RISKS OF CFDs. COMPLETED. ✅

Sources:

1. https://www.ig.com/sg/cfd-trading/what-is-cfd-trading-and-how-does-it-work
2. https://www.investopedia.com/terms/c/contractfordifferences.asp
3. https://thecashdiaries.com/2018/08/02/the-pros-and-cons-of-cfd-trading/
4. https://www.independentinvestor.com/cfd/how-to-lose/#:~:text=Between%2074%2D89%25%20of%20retail,%2C%20forex%2C%20and%20spread%20betting. 
5. https://www.plus500.co.uk/Trading/Forex
6. https://ext.com.cy/company/retail_risk_warning/#:~:text=CFDs%20are%20complex%20instruments%20and,risk%20of%20losing%20your%20money. 
7. https://www.cmcmarkets.com/en-sg/learn-cfd-trading/cfd-commissions-explained 
8. https://www.phillipcfd.com/pricing/#1474905391590-221bfc6b-d002 
9. https://www.drwealth.com/cfd-vs-dlc/ 
10. https://keydifferences.com/difference-between-otc-and-exchange.html 
11. Header photo by Pexels