Is trading CFD safe?

Are CFDs safe to trade? The short is “Yes” and the long answer is also “Yes, but it is a little complicated.” To put it another way, the dangers associated with CFD trading are more linked to the attitude of traders rather than to the nature of CFDs themselves. To ask whether CFDs are safe to trade is just like asking whether the sky is safe to fly? 

Risk vs reward

In the 1990s, CFDs were launched in London as a leveraged equity swap, and were typically used by hedge funds. However, they are now available on the retail market, so why not take advantage of this instrument?

Trading CFDs is safe and secure, but just like any other market, there are certain risks and rewards associated with CFD trading as well. In general, the correlation between the return on investment and level of risk is very strong, so to earn handsome profits, one has to put significant funds at risk. The reward is higher for high-risk trades because there needs to be something enticing that makes the trader take that risk. 

If you have a CFD account, but are not actively trading, your CFD account is safe, but not profitable. Each time you decide to trade, you are effectively putting some funds at risk in order to make a profit. If you trade a lot, you will risk a lot and vice versa. 

The same is also true for other asset classes such as gold and stocks. Buying gold is safe as compared to buying stocks, but stocks offer much better potential return on investment as compared to gold. So, the risk vs reward ratio for CFDs is just like any other asset class. 

Risk management

The appeal of CFDs is that you don’t need to trade the underlying assets. You will simply pay the difference between the buying price and selling price based on the contract. Doing so allows for much greater leverage so your opportunities of making handsome returns goes up significantly. With the upside, there is also a potential downside to leverage trading as well. 

Due to this potential downside, risk management is a very important aspect of trading CFDs. Without proper risk management, you can be seduced by the idea of making a lot of money while taking a lot of risk. This is just like buying a sports car and then driving it recklessly. It is always better to be safe than to take too much risk. On your CFD trading journey make sure you are as objective as possible and you always manage your risks. 

Risk is relative

Risk is something that is relative and everyone can have a different definition of it, as well as different tolerance for risk. You need to understand that risk is always closely related to reward so in most cases the higher the risk, the higher the reward. CFDs are no riskier than any other market but your trading attitude will have a big impact on whether you will make a profit or lose all your investments. Successful traders may even argue that trading CFDs is more about risk management than looking to make successful trades. You can use powerful tools such as technical analysis, probability and statistics to limit your exposure, while simultaneously increasing your profit ratio.

The right attitude

Whether CFD trading is safe or not also depends on the attitude of the individual trader. If you are a trader with a positive outlook and can-do attitude, you can make some serious inroads in the CFD trading world. If you have selected a reputable broker or a trading platform, did some research on your own, choose your leverage limits carefully and managed risk properly, there is no reason for CFDs to be riskier than any other asset class.

How CFDs work

CFDs or contracts for differences represent agreements between CFD brokers and investors. The agreement involves exchanging the difference in a financial product’s value from the opening of the contract to the closing time.

When an investor trades CFDs, they don’t have ownership of the underlying asset. The change in the asset’s value is the one that influences how much revenue the investor gets from it.

An investor can try to predict potential price fluctuations in underlying assets when they use CFDs. As such, they can bet on whether the value will go up or down. Then, when the price of the asset eventually rises after the trader has bought a CFD, that holding can be offered for sale.

The sale price and purchase price net difference created are combined. The investor’s brokerage account will then see the net difference which represents how much the investor has gained.

Meanwhile, the trader can place an opening sell position if they think there will be a decrease in the value of the asset. The trader then buys an offsetting trade to close the position. Their account will reflect the net difference.

The costs of CFDs

Different factors contribute to the cost of CFD trading. Usually, these factors include the spread, the financing cost, a commission, the offer price when you trade, and the difference between the bid price.

Brokers can charge certain commission amounts when it comes to stocks, even if trading commodities and forex pairs usually comes with no commissions. On top of that, if you take a long position, there may be a financing charge applied.

Advantages of CFDs

Trading CFDs typically comes with several benefits:

·  Higher leverage

One of the best things about CFD trading is that the leverage is high. When it comes to traditional investments, traders usually have to trade 100% of their capital when they wish to open positions. So, if they want to buy a $2,000 stock, that same amount of money must be committed to the investment.

CFD trading is different because its opening position current margin requirement is no higher than 5%. As opening a position doesn’t require too much capital, it’s possible for traders to significantly boost the possible profit margin.

Standard leverage in the CFD market used to be as low as a maintenance margin of 2%. Now, it is limited to a 3% range and could increase until it reaches 50%.

·  Global market access from one platform

A great thing about CFD brokers is that they provide products from all the large markets of the world. Moreover, traders have access to them at all times. This allows investors to trade in various markets from all over the world.

·  No shorting rules on borrowing stock

Shorting is quite complicated in some markets because they prohibit it. Therefore, before selling short, the trader is forced to borrow the instrument or at least have different long and short position margin requirements.

Meanwhile, you can short CFD instruments whenever you want without worrying about the costs associated with borrowing. This is because the underlying asset is not owned by the trader.

·  Professional execution with no fees

CFD brokers are not that different from traditional brokers as they also provide some of the same order types. They offer limits, stops, and contingent orders. In some cases, fees are charged in guaranteed stops for service. In other cases, fees will be charged differently.

When traders pay a spread, brokers can make money. Fees and commissions are charged at times. To sell or short, traders are required to pay the bid price. Simultaneously, they must pay the ask price if they wish to buy.

Based on how volatile the underlying asset is, the spread may be large or small. 

·  Variety of trading opportunities

The amazing thing about CFD brokers is that they offer multiple opportunities in trading. More specifically, they offer index, sector, stock, treasury, and commodity CFDs. As such, CFDS can be traded as exchange alternatives.

Disadvantages of CFDs

While CFDs come with numerous advantages, they also feature a few downsides. Here are some of the disadvantages you can expect:

·  Bad industry regulation – Unfortunately, there is not that much regulation in the CFD industry. This makes it less safe. The credibility of a broker is influenced by their experience, reputation, and financial position. You can find lots of amazing CFD brokers, and they will usually be safe. However, it’s crucial to do some research into the background of a broker before you make an account.

·  The spread has to be paid – Traders are required to pay the spread with CFDs. By doing so, the possible profit from small moves disappears. Moreover, winning trades are also decreased. CFDs may seem more profitable than traditional markets, yet spread costs also decrease the profits made by the traders. It’s something to keep in mind before getting into CFDs.

Example of a CFD trade

Let’s say that currently, a stock has an ask price of $25.26, with the trader purchasing 100 shares. The transaction will cost $2,526, although there may also be some extra fees and commissions. At least $1,263 in free cash is required for the trade when you’re trading in a margin account of 50% with a traditional broker. Meanwhile, CFD brokers have a low margin. This means that with a margin of 5%, a lower amount of cash will be required for the trade.

The loss in CFD trades will be the same as the spread size when the transaction is made. So, if the spread has a $0.05-cent value, the stock must obtain $0.05 in order to reach the break-even price for the position. If you already own the stock, you’ll be able to see a gain of $0.05, but you also have to incur a higher capital outlay and pay a commission.

When a $25.76 bid price is reached in traditional broker accounts, selling it can bring a gain of $50, or a profit of 3.95%. Then, the bid price of the CFD may be no higher than $25.74 when the price is reached by the national exchange. As the trader has to exit the bid price, there will be less CFD profit. The spread is also higher compared to the regular market.

Therefore, in this example, a CFD trader can earn around $48 or a return on investment of 38%.

Summary

So, to sum things up, we can see that trading CFDs is neither safer nor riskier than any other asset. The difference is all in your trading attitude, your risk management and your tolerance towards risk. If you make your trading decisions wisely, there is no excessive risk for you. Always practice safe trading strategy and always stave off the seduction of trading excessively with poor risk management. Trading is not a sprint, but a marathon and if you develop this attitude towards CFD trading, you can make some serious impact.