CFD Trading: Benefits & Risks
CFDs offer a flexible alternative to traditional investing and are therefore an attractive instrument for a wide variety of traders. New investors can trade CFDs successfully but you should undertake research and gain a thorough understanding of the benefits and risks involved before putting real money at risk. With the right preparation traders can take full advantage of the various positives that CFDs offer while limiting the potential downsides.
The advantages of CFDs
Here we have compiled a list of the advantages that are typically associated with CFD trading. Investors using a wide variety of trading strategies will find some or all of these factors to be compatible with their methods. The list highlights why so many different types of trader use CFDs as a means for speculating in the financial markets.
The ability to achieve gains in bull and bear markets
One clear advantage of CFD trading is that traders are not limited to establishing positions in only one type of economic environment (for example, posting buy positions in a bull market). The ability to trade in both rising and falling markets adds flexibility to your CFD trading strategy and allows you to forecast price movements that coincide with the underlying fundamentals (which can fluctuate in both positive and negative directions).
The ability to hedge positions
One method that investors use to limit potential risk is the implementation of ‘hedged’ positions. For example, if you have a long position on a stock that is accruing losses, you can open a position in the opposite position using a short CFD. This might seem redundant to some, but it will help to balance losses, as the short position will start to make gains if prices continue in a downward direction. This balance, or ‘hedge’, will thus allow you to limit risk and prevent future losses.
Flexible contract sizes
Many CFD brokers have a variety of trade sizes available which can be used for various trading styles or types of investment account. It is generally recommended that newer traders use smaller lot sizes until they have developed a successful trading strategy that makes gains over time. More experienced investors can choose to put more money at risk so that they do not feel limited in the way their trades are structured.
CFDs are generally offered for margin trading, which means that traders are only required to deposit a portion of the actual trade size in each transaction. For example, say you have a CFD share trade worth £1000 (either in a short or long position). If your provider’s margin requirement is 4%, this would mean you only need £40 to open the position.
The positive side of this is that you receive all of the gains made for the entire trade (not only 4% of the gained value). The downside, of course, is that you will also be responsible for all of the losses accrued in the trade. This would mean that if the £1000 trade moved 4% in an adverse direction, the value of the initial 4% deposit would be removed from your account. Margin trading is one of the most important aspects of CFD strategy as it generally accounts for the most significant gains and losses that are eventually seen – especially in the experience of new traders.
Risks involved with CFD trading
As with anything in life, CFD trading is not without its risks. Most of these potential negatives can be reduced with proper research and adherence to a structured trading plan. But you should remember that there is no way to eliminate risk completely. The best we can hope to do is to reduce the potential negatives, and to do this, the following points must be considered.
By far and away the biggest mistake that new traders make is the decision to risk too much on a given position. It is easy to see how this ‘over-leveraging’ happens, as inexperienced traders might look to CFD trading as a new career and a path to riches. When given the opportunity to place leveraged trades (with the potential of enhanced gains) many new traders abuse this opportunity and achieve major losses (or perhaps the destruction of an entire trading account) in the process.
If this sounds daunting, it really shouldn’t be, as this mistake is easily avoided. All it takes is a proper risk management strategy: using stop orders to limit the size of your losses, and risking only a manageable proportion of your overall trading capital on any one position. At all times traders should remember to be prudent, with the aim to create a long-term profitable series of CFD trades, rather than trying to hit a ‘home run’ at every opportunity.
Lacking voting rights
One final risk that many experienced CFD traders cite that share trading in CFDs does not give the individual trader voting rights at the underlying company’s AGM or elsewhere, such as a normal shareholder would enjoy. This is considered significant because once a position is opened, the trader cannot determine the future policy direction of the underlying company and is essentially powerless in terms of the direction prices will take.
With no ability to influence the behaviour or strategy of the company, CFD traders need to understand that, once a position is open, markets will dictate prices and traders must accept the results. This shows the importance of accurate forecasting and proper trade plans, so this is an aspect of CFD trading to which you should pay special attention.