Contracts For Difference (CFDs) are a leveraged derivative product. The potential for a large profit based on a minimal initial investment has been a contributing factor in the growing popularity of CFD trading in recent years. It also means that your losses can be magnified, rendering your exposure to high risk during CFD trades is greatly increased. We’ve talked about the cost of leverage before(link), so in this article, we’ll cover a few more in-depth risks associated with CFD trading.

Liquidity risks

Increases to risk of losses can be emphasised by market conditions influencing financial transactions. The risk of trading CFDs in a stagnant market is governed by the liquidity of your existing contract, so, if there are too few trades being made in a given market for an underlying asset, your contract could become illiquid. Similarly, if the market prices of a CFD drop before executing your contract at the previously agreed price, you could be liable for covering the losses incurred by the CFD provider.

Market Risk

Like stock, CFDs are derivative assets used by traders to gauge and predict the movement of underlying assets. As a result, the value of CFDs are very much subject to market volatility, so in the event of an unfavourable movement in the value of the underlying asset, your provider could require a second margin payment. If you find yourself unable to meet their demands, your provider can then choose to either close your position or sell at a loss.

Complexity

The truth is, CFDs are not a simple trading form. There’s no standardised practice for providers, so CFDs are all subject to individual terms and conditions, so staying on top of what’s being offered to you is really important for CFD trading success. Similarly, difficulty in accurate counterparty risk assessment also adds complexity to CFD trading, so doing your homework on the CFD provider or other counterparty to get a better picture of their financial security is a really good idea before entering into any contracts.

The reliability of your provider plays a large part in your CFD trading success because, even if your trading strategy is flawless, your ability to turn a profit still relies heavily on your provider’s ability to deliver.  This isn’t to say, however, that CFD trading shouldn’t be your next trading venture; in the next article (link) we’ll discuss the many benefits of CFD trading, and how the rewards can outweigh the risks.