Benefits and risks of CFD trading compared to other trading types

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Risks With Contracts for Differences (CFD)

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.

Counterparty Risk

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.

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 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.

CFDs vs share trading

Learn more about the differences between trading contracts for difference (CFDs) and share trading, and discover the benefits of each with our handy guide to CFD trading vs share trading. The page includes example trades and a detailed side-by-side comparison of the two types of trading to help you decide which is right for you.

Interested in trading CFDs with IG?

Contact us on 1800 601 799 or [email protected] about opening an account. We’re here 24hrs a day from 1pm Saturday to 7am Saturday (AEST).

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What’s the difference between CFD trading and share trading?

The main difference between trading contracts for difference and share trading is that when you trade a CFD you are speculating on a market’s price without taking ownership of the underlying asset, whereas when you trade shares you need to take ownership of the underlying stocks.

One implication of this is that you can take advantage of leverage when trading CFDs, meaning you’ll only need to put up a fraction of the full value of the trade – the ‘margin’ – to gain full exposure. This will amplify any profits, but also means that losses can exceed deposits. When you trade shares, on the other hand, you’ll need to pay the full cost of your position upfront so cannot lose more than you invest.

What are the different benefits of CFD trading and share trading?

Both contracts for difference and share trading offer ways to take advantage of price movements in financial markets – and both can form part of your portfolio. Take a look at the key points below to discover the different benefits of CFD trading and share trading, and decide which is best for you.

Trade a wide variety of financial instruments, including shares, indices, forex and commodities

Trade only shares and ETFs

Trade using leverage to spread your capital further and amplify profits

Pay the full value of your shares up front

Losses can exceed initial deposits on a given position

Limit risk to your initial outlay

Go long or short on a market’s direction

Trade only on rising prices

Positions are adjusted to offset changes from dividends

Receive dividends (if paid)

Trade around the clock on a number of markets

Trade only during stock exchange opening hours

No shareholder privileges

Receive shareholder privileges, such as voting rights on major company issues

CFDs Share trading
CFD trading Share trading

Comparison of a CFD trade and a share trade

Buying Barclays

A$208.10
(Margin = exposure x 5% margin factor)

A$4,162
(2000 shares at 208.1p)

A$418*
(20.9pt increase x 2000 shares = $418)

*Not including commission fees

A$418*
(4580 – 4162 = $418)

*Not including commission fees

The differences between CFD trading and share trading in detail

CFD trade Share trade
Underlying price 208 208
Our price 208 / 208.1 208 / 208.1
Deal Buy at 208.1 Buy at 208.1
Deal size 2000 shares 2000 shares
Initial outlay
Close price Sell at 229 Sell at 229
Profit
CFD trading Share trading
What is it? Trading a financial derivative – you deal on prices derived from the underlying market, not on the underlying market itself. Learn more about what CFD trading is and how it works. The buying and selling of physical shares in a company.
Are there expiries? No expiry dates (excluding forwards and options). No expiry dates.
When can I trade? We offer 24-hour trading on forex and major stock indices. During the underlying market hours for other markets. We also offer weekend trading on selected markets. Only when the related exchange is open.
Do I pay to keep
positions open?
Overnight funding on all markets, except futures. Rollovers on futures.
Does IG profit if I lose? We profit primarily from commission, spreads and funding, and hedge the majority of net client exposure. We accept a low level of market risk, from which we can make a small profit or loss. The outcome of a client’s DMA trade never has an impact on our profit or loss. We make our money from the commissions you pay on each trade. The outcome of a trade makes no difference to our bottom line.
What kind of trading
is it suitable for?
Intra-day
Daily
Medium-term
Long-term Investing
Can I receive dividends? We make a dividend adjustment on equity and stock index CFDs.
Can it be used for
hedging?
Rarely, as other products are more effective.
Range of markets More than 16,000 markets, including:
Forex
Stock indices
Shares
Cryptocurrencies
DMA forex
DMA shares
ETFs and ETCs
Metals
Energies
Spot metals
Soft commodities
Options
Sprint options
Interest rates
Bonds
Sectors
Stock index futures
Share forwards
Forex forwards
Daily stock index futures
Daily oil futures
Shares and ETFs only, but more than 13,000 from a range of stock indices in local denominations:

Australia:
ASX 200
ASX 300
And many other small cap Australian stocks

US:
S&P 500
DOW 30
NASDAQ 100
And many other small cap US stocks

UK:
FTSE 100
FTSE 250
Many other small cap UK stocks

Benefits and risks of CFD trading compared to other trading types

CFDs offer a flexible alternative to traditional investing and are therefore an attractive instrument for a wide variety of traders. New investors can trade CFDs successfully but you should undertake research and gain a thorough understanding of the benefits and risks involved before putting real money at risk. With the right preparation traders can take full advantage of the various positives that CFDs offer while limiting the potential downsides.

The advantages of CFDs

Here we have compiled a list of the advantages that are typically associated with CFD trading. Investors using a wide variety of trading strategies will find some or all of these factors to be compatible with their methods. The list highlights why so many different types of trader use CFDs as a means for speculating in the financial markets.

The ability to achieve gains in bull and bear markets

One clear advantage of CFD trading is that traders are not limited to establishing positions in only one type of economic environment (for example, posting buy positions in a bull market). The ability to trade in both rising and falling markets adds flexibility to your CFD trading strategy and allows you to forecast price movements that coincide with the underlying fundamentals (which can fluctuate in both positive and negative directions).

The ability to hedge positions

One method that investors use to limit potential risk is the implementation of ‘hedged’ positions. For example, if you have a long position on a stock that is accruing losses, you can open a position in the opposite position using a short CFD. This might seem redundant to some, but it will help to balance losses, as the short position will start to make gains if prices continue in a downward direction. This balance, or ‘hedge’, will thus allow you to limit risk and prevent future losses.

Flexible contract sizes

Many CFD brokers have a variety of trade sizes available which can be used for various trading styles or types of investment account. It is generally recommended that newer traders use smaller lot sizes until they have developed a successful trading strategy that makes gains over time. More experienced investors can choose to put more money at risk so that they do not feel limited in the way their trades are structured.

Margin trading

CFDs are generally offered for margin trading, which means that traders are only required to deposit a portion of the actual trade size in each transaction. For example, say you have a CFD share trade worth £1000 (either in a short or long position). If your provider’s margin requirement is 4%, this would mean you only need £40 to open the position.

The positive side of this is that you receive all of the gains made for the entire trade (not only 4% of the gained value). The downside, of course, is that you will also be responsible for all of the losses accrued in the trade. This would mean that if the £1000 trade moved 4% in an adverse direction, the value of the initial 4% deposit would be removed from your account. Margin trading is one of the most important aspects of CFD strategy as it generally accounts for the most significant gains and losses that are eventually seen – especially in the experience of new traders.

Risks involved with CFD trading

As with anything in life, CFD trading is not without its risks. Most of these potential negatives can be reduced with proper research and adherence to a structured trading plan. But you should remember that there is no way to eliminate risk completely. The best we can hope to do is to reduce the potential negatives, and to do this, the following points must be considered.

Over-leveraging positions

By far and away the biggest mistake that new traders make is the decision to risk too much on a given position. It is easy to see how this ‘over-leveraging’ happens, as inexperienced traders might look to CFD trading as a new career and a path to riches. When given the opportunity to place leveraged trades (with the potential of enhanced gains) many new traders abuse this opportunity and achieve major losses (or perhaps the destruction of an entire trading account) in the process.

If this sounds daunting, it really shouldn’t be, as this mistake is easily avoided. All it takes is a proper risk management strategy: using stop orders to limit the size of your losses, and risking only a manageable proportion of your overall trading capital on any one position. At all times traders should remember to be prudent, with the aim to create a long-term profitable series of CFD trades, rather than trying to hit a ‘home run’ at every opportunity.

Lacking voting rights

One final risk that many experienced CFD traders cite that share trading in CFDs does not give the individual trader voting rights at the underlying company’s AGM or elsewhere, such as a normal shareholder would enjoy. This is considered significant because once a position is opened, the trader cannot determine the future policy direction of the underlying company and is essentially powerless in terms of the direction prices will take.

With no ability to influence the behaviour or strategy of the company, CFD traders need to understand that, once a position is open, markets will dictate prices and traders must accept the results. This shows the importance of accurate forecasting and proper trade plans, so this is an aspect of CFD trading to which you should pay special attention.

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