The risks and rewards of CFDs: What you need to know
Introduction
Contract-for-difference trading is an ideal alternative to traditional investing since it can maximise capital investments, increasing your potential losses or profits. This approach of trading has increased in popularity, especially with some brokers providing negative balance protection to reduce huge losses that would result in massive account debts. So what are the risks and rewards of CFDs? Here are the most common risks and rewards.
Risks of CFDs
Liquidity and gapping risks
Financial markets fluctuate quickly, and the prices of stocks reflect this. Market volatility results in gapping, which takes place when stock prices shift suddenly from one step to another without going through the step in between. You’ll not always find an opportunity to place a market order.
And on the other hand, an investing platform may not find an opportunity to complete an order between the two levels of price. The most common effect of this is that stop-loss orders are completed at unfavourable prices, lower or higher than you anticipated, based on the trade direction. To limit the liquidity risk and the market volatility impact, you’ll need to apply an order boundary.
Counterparty risk
A counterparty is a firm that provides the asset in a commercial transaction. The contract that the CFD provider issues is the asset that’s being traded when purchasing or selling a CFD. The trader is exposed to the CFD provider’s counterparties in the process. The related risk is that the counterparties fail to meet their financial responsibilities.
If the provider isn’t able to meet these responsibilities, the underlying asset value is no longer important. Keep in mind that the CFD trading sector isn’t well-regulated, and the brokerage firm’s credibility depends on the financial position, longevity and reputation instead of government standing.
CFDs are leveraged products
Leveraged products provide investors with exposure to the markets by allowing them to deposit a percentage of the trade’s full value. That means while investors could make potential profits if the market shifts in their favour, they could as well make huge losses if the trade moves in the opposite direction, especially those that don’t have enough risk management measures in place.
Rewards of CFDs
Leverage
CFDs allow traders to trade on leverage, meaning they get massive market exposure with just a small original deposit. As a result, the potential returns on investment are larger compared to other trading forms. With leverage, traders only need a smaller percentage of the entire trade value in order to open the position and retain the same exposure level.
Profit from both falling and rising markets
CFDs allow traders to profit from rising and falling markets. If you believe an asset’s price will fall, you sell or go short, and you’ll earn a profit from each price fall. And if you believe an asset’s price will rise, you buy or go long, and you’ll earn a profit from each price increase. The opportunity to go short or long makes CFDs the most popular and flexible method of trading short-term in the current market.
Access to many markets
With CFDs, you don’t need to go to different exchanges and brokers for all your trading and investment needs. CFDs provide you with immediate access to multiple classes of assets under one room.
That means there is no need to transfer positions or money between different providers. It’s possible to trade CFDs under one platform across various markets, including shares, forex, cryptocurrencies, commodities and indices.
Keep in mind that, similar to any other investing form, there’s a real possibility of making money as well as losing it. That is why you need to have enough knowledge.