CFDs – Understanding the risks
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Unlike with traditional buying and selling of stocks and shares, there is a potential to lose more than the sum that you invested when buying CFDs. There are also costs involved with CFDs and keeping them for more than a day. It is important to be fully aware of the amount of risk that you are taking on when you adopt a position on a CFD, so that you can be sure that you are making rational decisions. In short, if you are a novice, it is important to ensure you have sound knowledge and a decent CFD trading education from a provider.
CFDs, or contracts for difference, are financial derivatives. You can buy CFDs that state if the share increases in value above its current level then you will receive the difference between the current value and the value when you close your position. Similarly you can buy CFDs that state you will receive the difference if the share declines in value below its starting price. If the share moves in the opposite direction to your prediction then you will have to pay the difference to the CFD provider.
The major source of risk with CFDs is that providers allow the use of leverage. They will let you buy a CFD by investing as little as 0.5% of its value. This investment is called the margin. If the price of a CFD moves against you then your margin can be wiped out very quickly. This will result in the CFD provider contacting you to request that you deposit more money. If you don’t cover your margin within a certain time then you will generally lose your position.
In order to guard against unacceptable losses CFD traders set stop loss orders. These automatically close a position when the price reaches a certain value. A risk associated with setting stop loss orders is that in periods of volatility there may be no opportunity to close your position at the price you have set, which will result in your position being closed at a less favourable price. This can also happen when a position is held overnight and the price of the underlying stock or share opens at a significantly different level.
Holding positions overnight can be a source of risk in and of itself. CFD providers charge a holding cost to anyone who keeps a position open after 10pm UK time. These holding costs are small individually but can mount up over time and are capable of wiping out profits or adding to losses.