In finance, contracts for differences (CFDs) – arrangements made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities – are categorized as leveraged products. This means that with a small initial investment, there is potential for returns equivalent to that of the underlying market or asset. Instinctively, this would be an obvious investment for any trader.Unfortunately, margin trades can not only magnify profits but losses as well.
The apparent advantages of CFD trading often mask the associated risks. Types of risk that are often overlooked are counterparty risk, market risk, client money risk, and liquidity risk.
Key Takeaways
- A contract for differences (CFD) allows a trader to exchange the difference in the value of a financial product between the time the contract opens and closes without owning the actual underlying security.
- CFDs are attractive to day traders who can use leverage to trade assets that are more costly to buy and sell.
- CFDs can be quite risky due to low industry regulation, potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses.
Counterparty Risk
The counterparty is the company which provides the asset in afinancial 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 credibilityis based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it's important toinvestigate a broker's backgroundbefore opening an account. In fact, American customers are forbidden from trading CFDs under current U.S. regulations.
Market Risk
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 whereCFDs 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.
FAQs
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.
What is the risk of contract for difference? ›
The main risk is market risk, as contract for difference trading is designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, which amplifies risk and reward via leverage.
What are the disadvantages of contracts for difference? ›
Disadvantages of CFDs?
- Leverage. Leverage can be a double-edged sword with CFDs—it can either work for or against you. ...
- Lack of ownership. Another significant drawback with trading CFDs is that you do not have any ownership of the actual asset, unlike trading shares. ...
- Overnight financing.
But, unlike shares, when you trade a CFD you don't own the underlying asset. Instead, you speculate on its price movement. You agree to pay the difference in price of the underlying asset between when the contract opens and closes: if you 'buy' a CFD (a 'long trade'), you expect the value of the asset to increase.
What is the biggest risk when trading a CFD? ›
You can lose more money than you expected when trading CFDs, as losses are based on the full value of the position, rather than just the margin deposit. This is a risk that comes with trading on leverage. Learn how to combat the risks of CFDs using risk-management controls.
What is the most significant factor that makes contracts for differences a higher risk than trading in futures? ›
CFDs are attractive to day traders who can use leverage to trade assets that are more costly to buy and sell. CFDs can be quite risky due to low industry regulation, potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses.
What is the rule against difference contracts? ›
The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers.
What are the disadvantages of the UCC? ›
Arguments against UCC involve freedom of religion, lack of consensus, and threat to cultural diversity. Pros of UCC include promoting secularism, equality, and gender parity; cons include difficulties due to religious diversity and sensitive implementation.
Is contract for difference legal in US? ›
Part of the reason why a CFD is illegal in the U.S. is that it is an over-the-counter (OTC) product, which means that it doesn't pass through regulated exchanges. Using leverage also allows for the possibility of larger losses and is a concern for regulators.
What are the advantages of the UCC over common law? ›
One of its advantages is the consistency and predictability of the UCC over common-law contracts. Since the UCC has been accepted in some form by all states, there is more consistency in the interpretation and implementation of contract law between countries.
The primary reasons for the ban are concerns over the lack of transparency and the risks associated with leveraged trading. CFDs are over-the-counter (OTC) products, meaning they are traded directly between parties without going through a regulated exchange.
Why do most CFD traders lose money? ›
Over-leveraging. CFDs are highly leveraged financial derivatives, making them incredibly risky. While leverage allows CFD traders to control larger positions with a smaller amount of capital, it can very quickly escalate losses when the market moves against you.
Is a contract for difference the same as a swap? ›
A contract for difference (CFD) is similar to a total rate of return swap except that payment only occurs once on the contract expiration date. A CFD may have a single stock, a basket of stocks, or an index as its underlying reference asset.
When you trade CFDs, can you lose your full deposit? ›
Trading CFDs could be right for you if you're looking for a way to trade rising or falling markets, and if you want to open a position using margin. However, CFD trading is risky and you could make a loss greater than your initial deposit amount.
Do CFD brokers trade against you? ›
Many CFD brokers make money from trading against their clients and profitable clients make them lose money. This is similar to how casinos operate. Casinos ban profitable customers.
What is the biggest error in CFD? ›
CFD errors can arise from various sources, such as modeling assumptions, discretization schemes, numerical algorithms, boundary and initial conditions, and code implementation. These errors can be classified into three types: truncation error, round-off error, and iteration error.
What is the contract for difference? ›
A contract for difference (CFD) allows traders to speculate on the future market movements of an underlying asset, without actually owning or taking physical delivery of the underlying asset. CFDs are available for a range of underlying assets, such as shares, commodities, and foreign exchange.
What are the risks of a contract? ›
For contracts, the four most common risk categories include financial, legal, security, and brand. In many cases, your contract risks are closely related to each other and often have a domino effect. A brand risk may trigger a financial risk, or a security risk may trigger a legal risk.
What is the basis risk of a contract? ›
Basis risk arises when the price of a futures contract does not have a predictable relationship with the spot price of the instrument being hedged. When basis risk is introduced to a scenario, it may mean an alternative hedging method would provide a better result.
Which type of contract has the highest risk for the buyer? ›
Cost reimbursable (or Cost Plus) Cost reimbursable (CR) contracts involve payment based on sellers' actual costs as well as a fee or incentive for meeting or exceeding project objectives. Therefore, the buyer bears the highest cost risk.
