CFD trading: opportunities and risks
CFD, or Contract for Difference, is a financial derivative that carries both high profit opportunities and significant risks. It is therefore essential that investors are aware of the possible consequences of this highly speculative instrument. In this article we take a detailed look at CFD trading and give advice on what investors should look for when choosing a broker.
A brief overview of CFDs
CFDs, essentially contracts for price differences, are arrangements between two parties who agree to equalise the difference in value between the opening and closing prices of a position. Originally used by professional investors in the 1990s, CFDs have found their way into the mainstream market. As derivatives, CFDs are based on underlying assets such as shares or indices. It is crucial to understand that investors do not buy actual shares or other assets when trading CFDs.
CFD trading involves both opportunities and risks. While substantial gains are possible, the potential for significant losses is equally real. It is therefore an area particularly suited to those willing to take the speculative risk on a range of underlying assets. Before entering CFD trading, it is advisable to thoroughly compare the offers of different online brokers, as their conditions can vary greatly.
How CFD trading works
CFDs, also known as contracts for difference, differ significantly from traditional shares in the way they are handled. They are predominantly traded over the counter (OTC). In this case, trading takes place directly between the parties involved, usually via a broker who sets the conditions, determines the buying and selling prices and provides various trading options. Therefore, choosing the right broker is of crucial importance.
CFDs offer investors the opportunity to profit from the price movements of leveraged financial instruments, be it indices, shares, currencies or commodities. The core of a CFD manifests itself in the difference, also called spread, between the opening and closing price. There are long CFDs, which can generate profits when prices are rising, and short CFDs, which offer advantages in a falling market environment. But it is equally important to stress that if you are on the wrong side of the market, you could face significant losses. In contrast to conventional securities investments, such as the purchase of shares or fund units, CFD trading is characterised by a lower capital outlay.
A particular advantage of CFD trading is the accessibility of assets that are otherwise difficult to reach for the average investor. Whether it is CFDs on interest rates, DAX futures or exotic commodities such as coffee and orange juice, the market offers a variety of exciting yet risky trading opportunities. In addition, investors can also bet on specialised indices, such as the DAX, and thus further diversify their investment strategy.
The leverage effect in CFD trading
An outstanding feature of CFDs compared to traditional stock trading is the ability to trade with a fraction of the actual transaction value. Instead of the full amount, investors only pay a security deposit, known as a margin. The amount varies depending on the specific underlying asset being invested in. This principle is referred to as leverage. This can significantly reduce the initial investment costs, which are often only between 1% and 10% of the total trading volume.
Leverage is a central component in CFD trading. It offers investors the opportunity to multiply the potential of their investment amount. However, it is important to emphasise that while leverage offers the possibility of increased profits, it also brings with it the risk of greater losses.
Regulation of CFD and Forex trading
On 1 August 2018, the European Securities and Markets Authority (ESMA) brought into force new, stricter regulations for trading CFDs and in the forex market. One of the most striking changes in these regulations is the limitation of leverage to a maximum of 1:30. However, the exact amount of leverage allowed varies depending on the asset class. This affects different investment products such as currency pairs, commodities, indices and shares. In order to better protect investors and minimise systemic risk in the financial system, these leverage limits have been enshrined in law. Here is a brief overview of the maximum leverage limits set:
- 1:30 for major currency pairs
- 1:20 for other currency pairs, gold and major indices
- 1:10 for other commodities and smaller indices
- 1:5 for equities
- 1:2 for cryptocurrency
Since 1 August 2018, the so-called margin close-out rules have also come into force, which, in addition to the leverage restriction, represent a further protective mechanism for CFD investors. In concrete terms, this means that if the value of an investor’s portfolio falls to less than 50% of the required margin, the investor must be forced to close out all open positions. This serves to minimise the risk of major losses. Another important component of the new regulations is the transparency obligation for CFD brokers. They must explicitly publish risk information on their websites. This includes stating the percentage of their clients who suffered losses in the previous quarter.
Choosing the Right CFD Broker
- CFD broker’s trading platform:
- A modern and powerful trading platform is at the heart of your CFD trading.
- Check whether the broker provides intuitive software specifically designed for CFD trading.
- The charts and analysis tools integrated into the platform should be up-to-date and allow you to track market changes in real time.
- In an era of digitalisation, a quality broker should offer such essential functions free of charge.
- Product diversity and choice of CFDs:
- The breadth of the product range can have a significant impact on your trading strategy.
- A quality broker should offer a wide range of indices, equities, futures, currencies and commodities to allow diversification and tailored trading strategies.
- Trading fee structure:
- The cost structure can have a significant impact on your returns.
- Investigate not only the obvious trading fees, but also hidden costs such as custody fees or inactivity fees.
- A clear and transparent fee schedule is a sign of a broker’s seriousness.
- Conditions for overnight positions:
- If you want to hold positions beyond the trading day, the conditions for so-called overnight positions play an important role.
- Different brokers can have widely varying remuneration or costs here, which can influence your returns.
- Risk and money management strategies:
- Prudent trading requires effective risk management tools.
- Check whether the broker offers advanced order additions such as trailing stop, stop loss, limit or take profit.
- These features can help you consistently implement your trading strategy and limit potential losses.
If you decide to trade CFDs, you need to know all the available offers in depth, which will help you find the right provider and perhaps determine the results of our work. You should not forget that trading CFDs involves risks, the consequences of which are often difficult to predict. It is the ideal way to make money for very experienced and highly speculative investors who are well acquainted with the risks. This type of trading is not recommended for beginners, as they can easily fail and lose all their money.