CFD Trading Risk: A Beginners Guide
CFDs are now one of the most popular forms of trading and have increased significantly over the past few years. But trading CFDs as a beginner can be confusing and frustrating. That's why we've outlined all the risks of trading Contracts for Difference (CFDs).
7 steps to navigating the risks of CFD trading while still reaping the rewards
- How CFD trading works
- Understanding how leverage and margin works in CFDs
- Why trade CFDs with us?
- Why trade CFDs?
- What are the risks of trading CFDs for beginners?
- Learn how to potentially mitigate the risks of trading CFDs
- Other CFD risk considerations: Liquidity risk
How CFD trading works
CFDs, short for Contracts for Difference, is a way to trade that works as a type of financial agreement between two parties (a buyer and a seller), who speculate on the price movement of an underlying asset. This means that you aren't buying or selling anything outright and taking delivery of the asset, for example gold bullion or company shares. Instead, you're using CFDs as a method of predicting if your chosen underlying market (for example a forex currency pair, a share price or an index) will rise or fall in value. If you predict correctly, you will generate a profit while if the market moves against you, you will end up with a loss, with the amount of profit or loss determined by your position size.
A CFD trading example
So, how does CFD trading work in practice? Let's say you believe that Tesla's share price will rise, and you've taken a look at the buy price and sell price. So, you go long or 'buy' with CFDs with your trading provider. Should the market move in your favour, with the Tesla share price rising, then you would have a running profit. If you closed your position by 'selling' your CFDs at this point, you'd receive the cash difference between the opening and closing price. There's always the risk that the market can move in the opposite direction, and the price of Tesla's stock could have fallen. If you had closed your trade at this point, you would have incurred a loss.
Understand how leverage and margin works in CFDs
Another important thing to know about CFDs is that they are leveraged. This means that you won't pay for the full value of your trade upfront before opening a position. Instead, you'll pay an amount called 'margin' that acts as a down payment, which is worth just a percentage of your full position's size. For example, if you wanted to open a CFD trade on gold worth $200, with a 10% margin requirement, you'd pay just $20 to open a $200 trade, essentially 'borrowing' the rest from your broker.
However, even though you don't have to pay the full cost to enter the trade, your profits and losses will be calculated on the entire size of the transaction, not just on the margin you paid to open the position. This means both profits and losses can easily outweigh the margin amount you've paid.
To further our previous example, say you decided to go short on Gold and you paid a margin of $20 to open your position on a contract for 100 ounces. Your assumption was that the gold price would fall but, instead, it rises. This means that you forfeit your $20 margin amount as a loss, as well as the entire difference between the price you entered the trade and when you exit the trade. When you open a leveraged trade, you need to be aware of the CFD margin level, given as a percentage, that will indicate how much of your position's full value you'll need available in your account as collateral.
You want to avoid the risk of your account being closed out (or coming dangerously close to it, which is called margin call), which happens if you don't have enough funds in your account. Depending on the platform you're trading on, your positions will automatically close if your balance falls below a certain level.
Why trade CFDs with us?
There are several reasons why you should trade CFDs with Pepperstone:
Mitigate your risk
Place stop loss orders to manage your risk with no restrictions.
Take advantage of our industry-leading, top-of-book liquidity, considered the best of the MetaTrader brokers.1
Enjoy more opportunities to trade due to our competitive quotes by multiple liquidity providers from Tier 1 Banks and institutions.
Cutting-edge trading platforms
Experience low-latency, fast execution on our 4 trading platforms and no dealing desk intervention for client orders (client placed trades or algos).
Boost your market awareness
Boost your market awareness with charting packages, analysis tools, market analysis articles, videos and educational content.
Benefit from faster price updates using our low latency location. Global clients can connect to our multiple data centres and access across the world.
What CFD markets can you trade with us?
Our CFD offering has been put together for traders of varying risk appetites and account sizes, who want to go long or short different asset classes.
With us, you can trade:
- Forex CFDs: take advantage of price movements in the FX market with leverage, for example if you trade the pair EUR/USD, without needing to physically hold the currency you are buying or selling. You can also trade a currency index CFD, which enables you to trade on direct changes in the value of a currency against a basket of other currencies.
- Share CFDs: speculate on the stock prices of the world's biggest companies, like Netflix and Apple, without having to take ownership of any shares.
- Index CFDs: trade on the rise or fall of major global stock markets like the NAS100, UK100, US500 and more without the hassle of having to trade and monitor a 100 individual share prices.
- Commodity CFDs: gain diversified exposure to various commodity sectors including metals, energy, and softs.
Why trade CFDs?
CFDs are popular for various reasons among beginners; they are considered a low cost, liquid trading instrument, giving you access to a range of markets and often being used to hedge risk.
Some benefits of trading CFDs include the following:
- Access to more capital due to leverage: you're able to gain greater exposure with a smaller amount of capital needed.
- Fast execution and confirmation of a trade being entered.
- Lower transaction fees: compared to, for example, buying an asset outright.
- Flexibility to go long or short: opportunity to trade on markets that are going up or down.
- Hedge your portfolio with CFDs: by executing short positions, traders can benefit from market downturn or protect their portfolio against adverse market price movements.
- Analyse the markets: smart trader tools allows you to set up trading strategies and EAs plus conduct technical analysis.
Let's explore in the table below some of the benefits related to specific CFD products:
|Currency Index CFD
What are the risks of trading CFDs for beginners?
CFDs are a very complex trading product – especially if you're a beginner. You'll need to know what you're doing in order to mitigate your risk. This will involve having the discipline to continuously monitor your positions, manage your risks with a trading strategy and keep a level head regardless of market volatility or your emotions.
Some risks of trading CFDs include the following:
- Leverage may cause amplified losses: you lose much more because you're trading on margin. That's why a stop loss is so important (we'll look at slippage later on).
- Over trading due to flexibility: if you're not disciplined to look at the size of your trade compared to your account balance, then you might place more trades which will result at more transaction costs that what you can afford.
- CFDs can be complex: they require understanding and grasping the maths behind the difference between the price at which you opened your position and what the price is now.
Trading CFDs as a beginner, you'll also quickly realise that there is a steep learning curve to understanding how it works and it varies from trader to trader. Here's some of the concepts that you might explore:
- Necessary losses (strategic loss taking over short and medium term) vs long-term success.
- How to be less vulnerable when it comes to consecutive losses and market volatility which can cause rapid changes in price.
- The ability to avoid common pitfalls.
- Learning to recognise false indicators.
- Gaining a balanced view of the financial markets with big-picture analysis.
As a new CFD trader, it also helps if you grasp what type of risk appetite you have, if you are naturally risk-averse or have a higher risk tolerance. Later on this page, we'll take a closer look at how to mitigate risk based on your natural trading style.
Learn how to potentially mitigate the risks of trading CFDs
Trading CFDs is risky, but even as a beginner you can learn how to be less vulnerable to risk. It is important to explore different solutions and money management strategies to reduce your risk – but also remember that market circumstances are always changing. Thus, there's never a guarantee that, just because a strategy worked for you before, it will go the same way the next time you trade.
Solutions to reduce risk: Stop losses, limits
You can minimise your risk of loss due to unexpected price changes in the market and extreme volatility with risk management tools such as stop losses and limit orders. When you set up a stop loss, your trade will automatically close when your position reaches a predetermined price – preventing you losing more than you're comfortable with.2 A limit order, on the other hand, will lock in profit by automatically closing a trade at a certain level automatically.
Solutions to reduce risk: Understanding the big picture with Technical and Fundamental Analysis
Another way to mitigate some of the risks associated with trading CFDs is to have a strategy in place or at least an understanding of the big picture. To do this, it's important to have a look at both fundamental and technical analysis. Fundamentals rely on economic studies and monetary policy actions while technical analysis makes use of price action and patterns to read, in real time, what is happening in that specific market.
Further on that subject, technical indicators could assist in studying markets but just beware of analysis paralysis and keep in mind that indicators have a learning curve and need to be understood well before being considered as part of a strategy.
Solutions to reduce risk: Automated Trading and Smart Trader Tools
Part of mitigating your CFD risk is constantly monitoring your positions. Not everyone can be glued to their screens, 5 days a week and that's where automated trading can be a useful solution. Automated trading enables you to set up execution orders that will automatically open or close positions on your behalf without you having to do anything.
Take it one step further with algorithmic trading, where you set up specific algorithms and parameters to automatically open and close long or short trades when certain market criteria and parameters are met.
You'll adjust your parameters based on your attitude to risk, for example a conservative trader will have much stricter parameters to suit their trading strategy.
You can also utilise Smart Trader Tools like the Trade Simulator, available on platforms like MT4 to backtest your expert advisers and algorithmic strategies.
Explore a risk-free Demo Account
Trading in general is high risk, and as an inexperienced trader you should always make sure you don't spend capital that you can't afford to lose. If you want to explore the world of CFDs and see how a trading platform works – but not risk valuable capital doing so – you can always become familiar with the markets using a demo account. Here, you'll be able to practise in a risk-free environment with a default amount of $50,000 (currency will depend on your region) in virtual funds. Clients can choose other amounts that may be more in line with their financial situation.
Other CFD risk considerations: Liquidity risk
A huge trading consideration for beginners or experienced traders wanting to trade on something using CFDs is liquidity – which is how many buyers, sellers and funds are moving in and out of your market at any given time. This is important, as it determines how easily you can get your order filled at the quoted price, in order to avoid 'price slippage' (difference between the anticipated price of a trade and the price at which the trade is executed).
In other words, how tight the spreads are and if you're able to get in and out of a position with ease, without ending up having your order executed at the next available price.
Slippage will typically happen if there is an imbalance between supply and demand, which causes a lack of liquidity.
At Pepperstone we execute 99.9%1 of all orders that we receive, with just a small portion of rejections to our retail clients, where there are liquidity or other market related technical issues.
Even better, we offer low latency trading. That means that, for pending orders like stops and limit orders you can count on very fast execution speeds which reduce slippage.
Can I lose money on CFD trading?
Yes, you certainly can make both profits and losses when trading CFDs, which is a leveraged product. Also, your losses will not just be based on the margin deposit, but on the full value of your position.
Are CFDs riskier than Stocks?
CFDs are complex financial products that offer higher leverage than traditional stocks, making them more risky in nature. It's important to remember that all trading involves risks.
Why do most people lose money on CFDs?
There are many reasons why traders could lose money trading CFDs. Trading involves a thorough understanding of market dynamics, price action, fundamentals of products, and other elements which could mean years of studying and watching. It's also important to understand how leverage works, how to navigate fast-paced markets, and among the most important factors, the risks associated with buying or selling such products.
1.Voted #1 Overall Client Satisfaction by traders in the 2022 UK Investment Trends Leverage Trading Report. More info here - Pepperstone.com/en/go/tradingview.
2. If the bid price for a sell Order or ask price for a buy Order is reached, the Order will be filled as soon as possible at the price available in the market. We can't guarantee that Limit Orders or Stop Loss Orders will be executed at the specific level or amount you set.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 78.8% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.