Contract for difference, commonly known as CFD is a contract between the buyer and the seller, describing that the buyer will pay the seller the difference between an asset’s current values then the buyer pays instead to the seller. It should be noted that the difference must be negative for the contract to be effected. Such contracts are financial derivatives thus allowing traders to take advantage of prices moving up and down.
There are various risks associated with contracts for difference. Let’s highlight some of these problems and possible solutions. One of the leading companies that’s in a better position to deal with such contracts is CMC markets.
Leverage Risk
Trading with leverage can be a good way of stretching your capital. As a forex trader, you can leverage funds available in your account and possibly generate larger funds in relations to the money you invested. However, this advantage comes with potential risks. There are also chances that losses can be greater than the total margin held, commonly referred to as a double-edged sword. There are steps you can take to mitigate these risks. Firstly, it is important to understand that you can incur huge losses when trading on margin. When your account drops below the minimum margin requirement, the best thing to do is a margin closeout. This is to prevent you from losing money than what’s in the account.
Risks of Trading Multiple Markets
Having a wide focus on potentially hundreds of markets across the world can lead to missing of some of the best trading opportunities. This happens due to lack of focus. It’s thus important to focus on a narrow trading area for easier monitoring. Start with shorter watch list. It’s possible to miss out on lucrative market moves when watching too many market at the same time.
Transact Only With Reputable Forex Brokers
When online forex trading was introduced, fraud was a common problem. This is now changing since great inroads have been put in place to scrap out unscrupulous brokers. However, you still need to be vigilant when settling for a forex broker. A good way of differentiating between a legit and a con is through insisting upon regulation. Only deal with a broker who is a registered member of a recognized regulator.
Liquidity Risk
CFD trading is associated with high liquidity risks. There are chances that a broker may liquidate all the CFD positions of the trader if he/she is unable to cover a loss. This primarily means that the investor stands to lose more money than his/her initial capital investment. As a trader, you may limit this risk through applying a guaranteed stop-loss order or an order boundary.
Stop Loss Orders
Stop loss orders can be set to push a trader out of the market. Market makers have the ability to control stop loss orders. This may increase your chances of getting out of the market, if it is not working on your favor. The best way to counter attack this problem is to go for providers who offer guaranteed stop loss orders. This is where a trader pays premium for a price to be guaranteed should a stop loss price be effected.
CFD Providers
CFDs are primarily traded over-the-counter with either a broker or a CFD provider. The CFD providers determine margin rates and contract terms. Trading is done under two different models; market maker and direct market access. The latter is recommended since its contract terms are designed in such a way that there is minimum conflicts of interest between the CFD provider and traders.
Market Risks
As noted earlier, the contract basically entails paying the difference between the opening and closing price of the underlying assets. CFDs are traded on margin rates, which can be quite small. It is quite risky for a small amount of money to hold large positions. One of the solutions is the use of stop loss orders. Traders deposit a given amount with the CFD provider to cover for any potential loss.
