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Disadvantages of CFDs

Contracts for difference are an attractive instrument for traders looking to diversify their portfolio on a number of counts, not least because they provide a degree of leverage to amplify the potential gains. But CFDs, like most tradable instruments carry their own disadvantages, and any proper consideration of the role of CFDs must pay due attention to the drawbacks and potential dangers associated with trading of this kind.

The primary and by far the most significant drawback with trading CFDs is the potential for significant losses beyond the initial contract value. Leverage can be a fantastic tool when the going is good, but it can have disastrous consequences when markets move against you, and it is often the ruin of inexperienced or overzealous traders. Remember that leveraged positions can go up and down, and that your entire deposit balance and more is vulnerable to the dreaded margin call.

When trading with margined products, it is essential to work with tight stops to prevent runaway positions wiping out your bank balance. While the upside gains are more than enticing, keeping a cool head and a realistic perspective on your trading is a vital component to minimising your losses and developing a longer-term, profitable and consistent trading strategy.

As a holder of CFDs, you also lose out on the rights associated with share holdings. This can be a disadvantage in respect of voting rights and having a say in how the company is managed, and you have no ownership in the underlying company itself - merely a contract relative to the index price of the security.

However, with CFDs you do benefit from dividend payments and other such corporate developments, albeit at a fractional rate compared with the share payout. It is therefore essential to make sure you factor in potential forthcoming dividend declarations, particularly when you're going short, as this could have a bearing on the value of your CFD positions and consequently the degree of profit you're able to draw from a particular transaction.

Furthermore, adopting significant long-term positions can be a costly business when trading CFDs, with commissions payable on the total transaction value and financing costs for the margined portion steadily increasing as time marches on. This is not necessarily disadvantageous, and the right position could easily wipe out the costs associated and still leave a healthy margin for profit. However, for less experienced traders or for positions with less volatility, these costs can at times become prohibitive to profitable trading, forcing the trader to look on a more short-term basis for his profits.

While this is undesirable for the trader, it performs a crucial role in limiting the exposure of the broker to risk, and thereby makes trading CFDs possible. Without the need for financing and comparatively large commissions, traders could notionally hang on to positions for decades and cash out on the natural upwards movements of the index, leaving brokers with a ticking time-bomb of contracts to be traded. By pricing this option largely out of viability, brokers can continue to offer CFDs as a trading instrument, and provide the added benefits of CFDs to a trading portfolio (albeit over a shorter-term period).

CFDs can be a truly excellent add-on to your existing trading, and regardless of your strategy or trading style there are benefits to be had in including these instruments as part of your portfolio. That said, it remains of vital importance to fully understand the risks and the disadvantages of trading CFDs before your exposure becomes too deep, to minimise the potential for losses and ensure you're in the best position to strategically build your investment portfolio.

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