CFD Risks

Market Risk

What the contract does is paying the difference occurring between the closing and opening prices of an asset and this implies the market risk as main risk of CFDs. Trading CFDs takes place on margin so the risk is significantly increased by the leveraging effect. The typical margin rates are usually small so holding a large position doesn’t require a large amount of money. Because of this risk CFDs are used in order to hedge elsewhere the existing positions or to speculate on the financial markets movements. Stop loss orders are another instrument used for mitigating this king of risks. Traders deposit a certain amount of money to CFD providers so they can cover the margin. When the market moves in the opposite direction, it can cause a greater loss than the value of the deposit.

Liquidation Risk

When the prices move in the opposite direction of the open CFD position, then, in order to maintain the level of margin, it is needed an addition variation margin. To cover this difference, the CFD provider can ask for an additional deposit from the party, which may happen with very short notice due to the markets’ fast movement. The positions may even be closed or liquidated by the CFD provider if additional funds are not deposited in time, so the trader may face a loss which falls under the other party’s liability.

Counterparty Risk

Counter party risk is another CFD risk dimension. It is considered a risk factor in almost all the OTC (over the counter) traded derivatives. In case of company default, to prevent client balances damages the over the counter CFD providers have to segregate the client funds. Less counter party risks are thought to have clearing house exchange-traded contracts. The clearing house is also included in the risk added by the counter party involvement.

CFDs versus other products

For financial markets speculations there was a number of various financial products developed and used. There were different kinds from physical shares via margin lending or direct to derivatives like options, futures and covered warrants. CFDs were promoted as alternatives by several brokers until they gained much popularity compared to the other financial products.

The London Stock Exchange is estimated to bare around 20 – 40 % of its volume in hedging accounts related to CFDs. There are voices who support the fact that 1/3 of the Lond Stock Exchange volume is represented by accounts related to CFD. Although there isn’t a clear monitoring on the London Stock Exchange for CFD generated volume, the 25% estimate appears to come from someone inside the LSE.

CFD market is very similar to the options and futures market, but there are some major differences, such as:

• There is no price decay due to the lack of expiry date;
• Market makers and CFD brokers do the trading off-exchange;
• Contract for CFD is between only two parties and the instrument is underlined;
• US residents do not have access to CFDs;
• The size of the minimum contract is small