Disadvantages of CFDs - Risks of CFD Trading
Any serious treatment of CFDs has to honestly reflect on the disadvantages and risks that come with trading in such a highly volatile, highly risky way. While there’s no wish to dissuade traders from getting involved in CFDs and profiting from the various opportunities the markets pose on a daily basis, it is important that traders are fully cognisant of the risks and dangers of trading fundamentally complex financial products before throwing in their savings. Let’s look at the key disadvantages you should bear in mind as you go.
Right at the top of the list of disadvantages comes leverage. Ironically, the most important benefit of trading CFDs can also be its more significant downside, given the extent to which leverage can wreak havoc on your trading capital if you’re not careful. While a couple of percentage points in a favourable direction can leave you with a substantial return, the same movement against you can start to rapidly eat in to your trading capital, and you can quickly find yourself experiencing difficulties if you don’t get the balance of leverage right. The trick to making leverage work lies in not taking unnecessary risks. A slow and steady approach to investing with CFDs can help dramatically reduce the impact of leverage when positions inevitably go wrong, and minimising the risk element of leveraged trading is key to having any kind of success with CFDs.
In addition to the greater losses leverage can bring, CFDs also have a higher risk profile in the sense that the funded portion must always be accounted for. If the market drops a couple of points, the leverage part of the deal still has to be made up, in addition to funding costs which remain constant and any capital damage sustained over the course of the trade. This adds up to make CFDs a much riskier type of investment than, say, dealing in shares directly, because the extent of possible damage from each trade is so vast.
Risk of Overtrading
Similarly, because CFDs are a lower-cost way to access the markets, and because the capital commitment on each trade is lower than it would be investing through non-margined means, traders can quickly slip into the tendency to overtrade. Overtrading is where a portfolio is too exposed to the markets at any given time, such that the remaining capital would be insufficient to cover losses across the portfolio. Moving into overtrading territory is easy when trading is notionally so cheap, but this risks much more than a few lose percentage points on your capital. If multiple positions head south, it could spell disaster and even financial ruin for those that adopt a less than cautious approach.
Rigid Margin Requirements
Aside from the risks of positions going awry, CFDs also bring disadvantages on several technical counts. Margin requirements are one example of this. Unlike other forms of leveraged trading, such as forex, the margin portions of CFD transactions are set firmly by the broker, who decides what percentage of margin you’re required to stump up for access to a given market. This can vary across market to market and broker to broker, but serves as a restriction on the freedom of investment, in that some markets are afforded looser borrowing terms than others. Effectively, margin requirements can be obstructive to your wider trading plan, and introduces an additional layer of planning into the pre-trade process in order to determine how feasible a potential return may be.
Lack of Ownership
CFDs are not like buying in the share or commodities markets directly – there is no underlying ownership of anything other than the contract itself. When a trader buys a share, he holds an asset that delivers a periodic yield in the form of a dividend, and one that can be held for the long term if it doesn’t deliver a speculative profit. With CFDs, there is no such asset, and there is no intrinsic value lying in the CFD aside from its current market price. This lack of ownership makes CFDs a less robust investment prospect.
Cost of Overnight Financing
With CFDs being so highly leveraged, it's a case of the shorter the term, the better. Overnight financing costs kick in on a daily basis for every trading day that you maintain an open position, and these costs can quickly mount up if you intend to hold a position over a matter of weeks or months. While this may work out to be a financial wise move, in practice it tends to be the case that traders casting their eye to the longer term would be better to invest in other, more cost effective means of holding long-term exposure.
Having examined both the pros and cons of CFD trading, it's clear that while risky, CFDs are no doubt an attractive instrument for many traders to incorporate into their portfolio. But who actually trades CFDs in 'real life', and why, in practice, are they so keen to remain involved in such an apparently risky investment style?