The main risks of CFD trading
I have used “the main” because there may be more than I can provide you with here. I chose to focus on the most important ones, because those are the ones you are more likely to come across and will generally deliver more devastating effects.
1. The use of the leverage
CFD trading works with the help of the leverage. The leverage is the financial strategy of acquiring high value assets using a certain percentage of your own money (somewhere between 5% and 25%, depending on your choices and your broker’s options) and borrowing the rest from the broker or from a bank.
The leverage is the body and soul of CFD trading, which is why it appears so seductive to most people. The problem with leverage lies in how the mechanism works. In order to acquire a $10,000 asset, you only need to place, for instance, 10% of that asset’s value – $1,000.
What this means is that your position will be worth $10,000, despite you having invested only 10% of that amount. As a result, you will be leveraging a higher position with the help of a lower investment. And all your gains will depend on that higher position you control.
What this tells you is that you will be able to win a lot more money, with the same investment, by leveraging your trading position with the help of CFDs than you could ever win by resorting to classic trading options.
So, what exactly is the risk? The risk is that your losses will be multiplied by the same factor. Which means you might end up losing more than you have in your account. A lot more. Now you know.
Since you know how leverage works, you most likely understand how over-leveraging works as a concept too. We are talking about situations where inexperienced traders (aka you) go all-in and leverage the hell out of a given CFD position.
This is not a bad strategy in and of itself. It can actually be incredibly rewarding when you hit the jackpot and spot the perfect opportunity to do it. The problem is that the “perfect opportunity” may have different meanings, depending on who analyzes it.
For a beginner, the perfect opportunity could refer to a volatile situation that only gives the impression of stability. And if you resort to over-leveraging in a case like that, the amount of money you can potentially lose cannot be described in human words.
Because you have the leveraging system pumping the loss like an adrenaline shot.
3. The market’s volatility
This volatility could work both for you and against you. But we are more interested in the second part. If the market is volatile, it means you will have harder times to appreciate the real dangers. As a beginner, you will most likely ignore any CFD trading risks and go for the kill anyway.
Then the market swings the other way and take your head clean off. This is why it is crucial to avoid volatile markets or assets, especially if you don’t master the trading techniques of a genuine pro.
4. Becoming overconfident
This is only indirectly related to the risks of trading CFDs. The actual culprit here is overconfidence. Getting several hits in a row could make you feel invincible or give you the impression you are on a lucky spree and make you up the game.
Obviously, that is the opposite of what you should do. Because, in the CFD business, one mistake is enough to cancel all your wins up to that point and take you down from your pedestal faster than it took you to climb it.
Overconfidence is a real threat and I have seen it ruining people in the blink of an eye.
5. Going in the wrong direction
Here is the deal. A lot can happen in the trading business. As a beginner, your job is to make sure you have as many safety nets as possible. And by safety nets I mean information, because that is all that this industry is about.
This means you should never enter markets you don’t know and deal with assets you are not familiarized with. It is not worth the risk of not knowing how the said market will behave or what factors could destabilize the asset’s value.
Always know what you’re getting yourself into.
6. Not using the cut-losses options
I can’t stress enough the importance of this piece of advice here. You need to put stop-losses mechanisms in place to manage your margin account. It is imperative. Stop-losses will prevent you from being financially ruined overnight.
In general, different brokers will have different cut-losses options, most of which have a preventive nature, in the sense that they generally take effect before any loss actually occurring.
7. The hidden danger of holding costs
Depending on your broker, the holding costs may differ in value, as well as in the way they function. But, as a general rule, if you maintain a trading position for too long, holding costs will start pilling up and, next thing you know, you have to use any profits you may have got to cover those costs.
Which means you need to know when to leave your position, especially if it’s not doing that great. Last thing you need is more money to pay, when you already aren’t doing any.
8. Account close-out
This is always a danger if you are trading CFDs. The CFD markets are volatile in nature and things might not go your way all the time. This brings us to the fact that your broker might decide to suddenly close your position automatically, if you fail to maintain yourself above the margin requirement.
This is a measure put in place to protect both you and your broker’s assets, since you are working with a leverage, therefore using his money to keep your position afloat.
How risky is CFD trading you ask? As you can see, extremely. Not in the sense that it makes it absolutely unfeasible as a trading option, but enough to tickle your self-preservation senses. Now, for the most important aspect of them all – can you minimize the CFD risks?
Yes, you can and here is how.
The most important CFD risk management strategies
To be completely honest with you, I could accept you skipping the first part of the article, as long as you get to read this one. You could completely ignore everything I have said so far, if you just follow the next steps with a religious commitment.
We are talking about the most effective risk management strategies you can adopt to increase the safety and the efficiency of your CFD trading. And these are as follows:
1. Choose your broker carefully
Having an honest and reliable broker is priceless in today’s trading environment, where everyone wants a bite of what you’re chewing. A good broker should have transparent policies, should always inform you when he decides to change some of them, regardless how small the changes are, and he should be reliable.
The last thing you want is a broker craving for your money and lacking any sense of morality and honesty. This is why it is imperative to check the broker’s background and reputation before stepping into any type of long term collaboration.
2. Learn and adapt
Adaptability will come a bit later. What you need to focus on, in the initial phases, is learning as much as you can about how things work. Inform yourself on the movements of the market, which assets are hot and which aren’t, which are showing promise of becoming hot.
Learn how to predict outcomes, because that will tell you when a specific investment is worth it or not. And, last but not least, keep your mind open to everything new. Any tip or advice that could help you improve your game.
3. Always control your position
When trading with CFDs, the first mistake you are bound to make is to leave your position unsupervised. This could have dire consequences if the market decides to play a trick on you and simply slide the opposite direction.
If you don’t monitor your position up-close and personal, you won’t be able to prevent or minimize the damages in time. And eating a full blow is never fun. Even more, it could throw you in a financial grave.
4. Don’t take leverage for granted
You know how leverage works by know. You know it can deliver a lot of profit if you play it right and a lot of mess if you don’t. Treat it with respect, which means you should always go for safe bids (as safer as they can get) and look for anything that could cause you to lose your position.
Then, as soon as you have spotted the danger, move along to the next step, which is:
5. Use stop limits
Depending on the broker you might work with, you will have specific stop limits to prevent your margin account for being ripped apart by some unfortunate twist of events. Stop-losses are pretty popular among traders, because they stop the money leak and keep you on the floating line.
6. Stay modest and learn to control your emotions
One of the biggest dangers for a beginner is to fall prey to either his overinflated ego, following a series of wins, or to that kamikaze approach of going all-in, following a series of losses. Both can be extremely dangerous and can actually magnify your financial hole.
Remember that emotions have no part to play in the trading industry.
7. Stay updated with the news
The global economic sphere is extremely volatile as a whole. Sure, you have particular assets that are highly reliable, even in volatile markets. But, remember that in the trading market everything is linked to everything.
One major change in one sector can create a sudden unexpected domino effect that could send shock waves even in sectors you thought safe. You can limit those risks by remaining constantly hooked to the global news scene and adapt your game accordingly.
I have tried to be as exhaustive as I could in presenting you with all the risks you should expect. These are the most dangerous ones, because they either come with the system, like leverage, the market’s volatility or hidden brokerage clauses, or with you, the trader, like overconfidence or ignorance.
This is the reason I told you to focus primarily on the solutions, because those are the first steps you need to take on your way to become a pro.
All the precautions taken, let the games begin!