When you trade CFDs, you are essentially betting on the price movement of an underlying asset. If the underlying asset’s price goes up, you will make a profit; you will make a loss if it goes down.
While this may sound simple enough, new traders should be aware of many risks associated with CFD trading before starting trading.
The market is moving against you
The first risk is that you could lose money if the market moves against you. It is known as “underwater” or having “negative equity”. When your position is underwater, you will have to put more money into your account to keep the position open. If you don’t have enough money in your account, your broker will close your position automatically.
The price of the underlying asset going up or down too quickly
The underlying asset’s price could move up or down very quickly, meaning you could make or lose a lot of money in a short space of time. It’s known as “price volatility”.
The margin requirements
When you trade CFDs, you have to put down a “margin” – this is a deposit that acts as collateral for your trade. The margin required varies depending on the asset you are trading, but it can be as high as 20% for some assets. When the market moves against you, and your losses exceed your margin, you will be “margin called”, which means your broker will close your position and lose the money in your account.
The fees and commissions
When you trade CFDs, you will have to pay fees and commissions to your broker. These can eat into your profits or increase your losses. Make sure you understand what fees and commissions you will be charged before you start trading.
The leverage
CFD trading is usually done on a leveraged basis, which means you only have to put down a small deposit (the “margin”) to control a much larger trade size. It can exaggerate both your gains and losses. Before you begin trading, learn how leverage works.
The stop-loss orders
A stop-loss order is an instruction to sell a commodity at a specific price if it reaches that point. It’s used to limit your losses if the market goes against you. However, if the market moves quickly, your stop-loss order may not be executed at your desired price, meaning you could still make a loss.
The shorting
When you “go short” on an asset, you bet that the price will fall. While this can be a profitable move if the price does indeed fall, it is also riskier than “going long”, as you could make unlimited losses if the price starts to rise instead of fall.
The counterparty risk
When you trade CFDs, you enter into a contract with the broker. It means that the broker is your counterparty in the trade. If the broker goes bankrupt, you could lose all the money in your account.
The market risk
The markets are inherently risky, and anything can happen at any time. You could make or lose money regardless of how well you have researched an asset or how good your trading strategy is.
The political and economic risk
There is always the risk that political or economic events could cause the markets to move unpredictably. These events could include Brexit, Trump’s election or the coronavirus pandemic.
You might get lucky and make money
It’s worth noting that you may profit from your CFD transactions. It is critical to only invest in assets you are comfortable losing money.
You might never make any money
It’s also worth noting that many people never make a profit from CFD trading. Trading is a hazardous business in which few individuals have the knowledge or abilities to succeed.
In conclusion
CFD trading is a risky business, and new traders should be aware of the risks before they start trading. If you don’t understand something, ask your broker for clarification.