Contracts for difference have for some time been a vitally important feature on the professional trading circuit. Their ability to afford traders highly leveraged exposure to a variety of markets make them a flexible trading tool, and one that is invaluable to fund managers and professional investors looking to diversify their portfolio. Furthermore, as a relatively inexpensive way to trade on margin, thanks to the comparatively low commission and trading costs, CFDs are used widely in both professional and consumer investment spheres, designed to make larger gains over shorter periods of time.

However, CFDs have a bit of a reputation for being a highly risky trading product, and some financial commentators have even suggested that brokers take advantage of consumer investors who are relatively uninformed of the true risks of trading CFDs. So how accurately does this reflect the true state of affairs, and how much care should you take when trading CFDs?

How Risky Are CFDs?

CFDs are extremely risky. While much is written and spoken about the rewards trading CFDs can bring (all of it true), there is unfortunately (and for obvious reason) less spoken about the downsides. No one wants to ruin the party by bringing up the varied risks and threats posed by CFD trading, but it’s crucial that you’re aware of these factors before you commit your capital. CFDs are always highly leveraged, which means that even if positions go wrong you’re still liable for the amount you borrowed in leverage.

Added to which, often extremely volatile markets can make it difficult for traders to avoid losing from time to time. The trick is to manage the risks posed by CFDs, and the trader who manages to reduce their risk profile stands a better chance of profiting over time.

Trading contracts for difference, like any form of trading activity, can produce unpredictable results that may not necessarily follow any logic or pattern. Even the more well thought out and rationed trade can go wrong, and that’s the same with all elements of trading, regardless of the instrument concerned.

One core difference with CFDs, however, is their leverage. CFDs are heavily leveraged to deliver enhanced returns for traders, but this same leverage can also lead to serious problems when trades go wrong. Just as a fractional movement upwards is amplified by many times as a result of trading with leverage, so too are any losses, which can often impinge on other successful trading positions, or even result in a margin call from the broker.

Such is the severity of this downside risk, some analysts have compared the risks associated with CFDs to gambling, even when traders are fully researched and knowledgeable about the markets they are trading. While this is a common concern about CFDs in particular, and there are obvious distinctions between the two, it nevertheless goes some way towards underlining the scope for risk when trading CFDs.

The question then becomes “how best can the risks of CFD trading be minimised”, to which the answer is manifold. First and foremost, ensuring you understand the nature of the risks involved, and provided you have taken the effort to calculate your potential exposure to loss, it should be possible to contain the risks of reckless trading. Nonetheless, guaranteeing successful trading is impossible, and it is certain that you will incur losses from time to time as you move through your trading life cycle.

CFDs are, of course, a risky investment, and to plunge in without researching the markets and the trading fundamentals first would be nothing short of madness. No-one ever got rich through sheer guess-work, and only by being totally aware of the true extent of risks you’re exposing yourself to through trading contracts for difference can you start to make sensible, informed, investment decisions.

cfd risks

How Can The Risks Of Trading CFDs Be Reduced?

The risks of trading CFDs are posed largely by the risk of being exposed to the markets, so the best way to trade from a risk perspective is to keep your market exposure to a minimum. At the same time, this presents a key problem for traders – without market exposure, you can’t make money, so the best risk management strategy lies somewhere in the middle. While stops can be a useful tool in helping you minimize losses on individual trades, much of the risks of trading can be reduced through careful, thorough research and through devising a sensible strategy.

Cutting Out Risk In CFD Trading

When it comes to trading outlook, most traders start out with a glass-half-full approach. They focus on the strategies, tips and techniques that will earn them the most money from their trading, which often breeds enhanced appetite for riskier strategies and abuse of leverage. But what they don’t tend to focus on as much is the other side of the equation – reducing the risk exposure of their trading – which can have just as much (if not more) of an impact on overall trading fortunes. Money saved is as good as money earned in trading, particularly considering the frequency with which traders experience losing trades. CFD trading is a game of aggregates, so every penny you can minimise in loss is a penny that doesn’t have to be offset from your trading profits.

This is an important realisation for most traders, and can deliver significant financial benefits to their trading account. Part of the process of mitigating losses depends on cutting out, or at least reducing the risk profile of a particular transaction or trading strategy, and there are a number of practical ways in which this can be done.

Setting Stops

An effective way in which the risks of CFD trading can be contained is through the use of stop losses (and limits). Stop losses are guaranteed, automatic orders that close out your open positions whenever the price reaches a certain low-end trigger point. This is designed to guard against the possibility of runaway losing positions, and allows you peace of mind in knowing that your downside loss is limited. It is absolutely imperative that you set stops wherever you can, and as tightly as you can (taking into account some breathing space for positions that might tick in either direction on the road to profit). By using stops to their fullest potential as a cap on your downside liability, you are taking an incredibly important and often understated step towards minimising you potential losses.

Narrowing The Angle

A similar technique for using stop losses in an efficient way is by narrowing the angle for losses – i.e. by dragging your stop loss up with your position as it moves into profit. This effectively allows you to ‘bank’ portions of your profit without sacrificing your exposure to the position, and by consistently lifting the cap at which your position will automatically be settled, you are capitalising on the profits you’re already earned, rather than allowing them to be swallowed up if the market reverses. This is an important and highly effective strategy for closing down the potential for heavy losses, and helps ensure that you can maintain positions for as long as they remain profitable.

Managing Leverage Responsibly

Dealing with CFD leverage in a responsible and effective way is not something that is often taught in CFD trading manuals, but it is nevertheless one of the best ways to make sure you aren’t inviting risk in to your trading account. Encouraging risk is the worst thing you can do as a CFD trader, and by abusing leverage you’re really asking for trouble. To manage leverage in a responsible and measured way takes discipline, but also an understanding that risks are inherent and ever-present in any form of leveraged trading. By appreciating the severity of the risks involved, traders can begin to understand how best to use leverage as an investment tool, allowing them to better judge how heavily to back a given position.

Cutting out the risk component of CFD trading entirely will sadly never be a possibility, but it is within the reach of every CFD trader to lower their exposure to loss, and in doing so to improve the efficiency of their trading. By safeguarding trading profits and cutting out losing behaviours, it is possible to maximise your returns from CFD trading by playing the game in a smarter, more informed way.