In this article, we will be going through the four main risks in trading CFDs. These are leverage risk, counterparty risk, liquidity risk, and order type risk.
Let us start with leverage risk. Leverage risk allows you to diversify your portfolio with ease. With leverage, if a company moves in our favour you will still have a big advantage, as this means that we would have a good gain in our portfolio with a small amount of capital. However, the risk of leverage means that the reverse is also true. Should the market move against your favour you will incur a greater loss and this can lead to a deficit amount in your account, which would require you to top up your account to meet the minimum margin requirement, or even liquidate your current position so as not to incur any further losses.
Let’s now move onto counterparty risk. CFD is an over the counter product traded on an off-exchange basis, meaning that it is subjected to a separate regulatory machine.
What does counterparty mean? Imagine that you are at the supermarket buying groceries. In order to buy, someone needs to sell the goods to you, in this example it would be the grocer or the supermarket. Hence, the grocer or supermarket would act as your counterparty in this case. In the context of trading, when you buy a buy trade with say, CMC Markets, you would have to purchase this contract from a willing seller. This works both ways as every willing buyer must be accompanied by a willing seller. The seller would then be the counterparty. Hence, when you place a trade, you will either be acting as a counterparty or affecting your trade with a counterparty. You might then ask what risks are involved in this? Counterparty risk arises when the CFD provider is unable to meet their payment obligation when it falls due under a CFD. For example, when you place an initial trade over a certain period of time, the trade is making a profit. In the event that you want to close the trade, counterparty risk occurs when the counterparty in this transaction is unable to fulfil the request, resulting in you being unable to exit out of your current position. As you are the holder of the contract, you should note that you have no recourse to the underlying shares, as you have not actually bought these shares, but instead simply purchased its Contract For Difference.
What about liquidity risk? As CFD is an over the counter product, subjected to buy and sell prices, including volume, some CFDs have lower liquidity than others which makes it more difficult to trade at the market price. This could result in a CFD not being made available for sale for a specific period of time. Or, if it is being traded, it may not be traded at a fair value. For example, let’s say you have bought a CFD and you are now earning a profit from it. Over a period of time its liquidity reduces, resulting in a lower trading volume of the underlying stock or share. In this scenario, you could either sell your CFD at a lower price, which could result in lower profit or loss. This is what we call liquidity risk.
Lastly, let’s talk about order type risk. You can place more than one order type. For example, you may place a stop limit order. The goal of these order types is to limit the losses and to maximise your profits. However, it is important to note that given the different types of orders that you can make, you are still subjected to the movement of the markets. Hence, there might be situations where the market would make it difficult or impossible to execute such orders without incurring losses. For example, perhaps you would like to go short and therefore you place a limit order. But due to market conditions there were not enough scrips which resulted in the order not being carried out.
We hope that this article helps you understand the various risks involved in trading CFDs. This article is purely for educational purposes and is by no means to be taken as advice.