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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.

CFDs Are Risky and Leveraged

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.

Factor In Dividend Payments

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).

On the Bright Side – Advantages

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.

More Risks of CFD Trading

Trading contracts for difference is a risky business by its very nature. The high returns that are up for grabs can only really come about with a corresponding high-risk profile, and for traders that dare to meddle with leverage, the penalties for getting it wrong can be harsh, swift and severe.

Aside from the risks of simple errors of judgement or ill fortune in trading CFDs, there are also a number of inherent risks in investing your capital which must be given due consideration. The successful trader should be able to recognize the diverse range of risks facing his portfolio, so that further risks can be minimised to reduce potential losses. But what do these risks look like, and what can they mean for your portfolio?

Market Risk

Every trader who has ever taken exposure in a market has faced market risk, and in many cases it has been a central contributing factor to the demise of successful traders. Market risk is the risk inherent in the market: that is, that the value of investing in the markets generally will fall, and investors will move their money into alternative markets. Over time, most traders assume that the markets will generally trend upwards. Market risk is the threat posed by markets drifting downwards, and is a factor that can externally act to depress the value of your trades and positions.

Liquidation Risk

For CFD traders in particular, the liquidation risk posed by exposure to the markets is significant and a constant factor to bear in mind throughout the duration of the trade. Liquidation risk is essentially the risk of a position or multiple positions across your account being liquidated at the demand of your broker in the event that you face a margin call for one or more of your trades.

A margin call is essentially a demand for a top-up to the margin requirement, which can come about as positions change in value. This risk of throttling profitable positions simply because of liquidity risk from other trades is one that requires careful financing planning to minimise. Know how much you’ve got invested, and know how much you’re likely to need in cash as a buffer to support your positions as they develop – this is critical to your success.

Counterparty Risk

Counterparty risk is the risk that arises from dealing with a third party for trading purposes. In most cases, the counterparty risk to CFD transactions will stem from the broker, who is of course the counterparty to the trade. What this risk essentially entails is the risk that the broker will default or become insolvent or be otherwise unable to honour its obligations. Naturally, this risk is minimised by choosing a reputable broker, but it is nevertheless a risk to bear in mind, and many traders spread their trading capital over different brokers to avoid being too heavily exposed to the counterparty risk of any one provider.

These inherent risks are shared by all CFD traders, but that’s not to say they should be overlooked. Understanding the threats to your trading capital is the first step in building in solid defences within your portfolio – critical for protecting your capital and weathering the storm for when markets inevitably periodically run against you.

Contracts for difference have a number of key advantages over other trading products, and as an instrument CFDs are increasingly becoming the tool of choice for professional traders. Traded off-exchange through a broker, CFDs are naturally leveraged products, and benefit from favourable regulatory and tax treatment to give a significant leg up over competing products.

CFDs Offer Leverage

Perhaps the most immediately obvious advantage of CFDs is that they are margined products, providing an in-built leverage component to maximise earnings. In laymen’s terms, this means you can invest more heavily than your balance allows, borrowing the remainder on a short-term basis from the broker (with all applicable interest).

Essentially, this makes it possible to invest 10, 50, 100, 200 times more than your available resources, reaping the accrued profits from movements in your favour – ultimately helping you to earn more from your CFDs over a shorter period of time, and without the same personal exposure as with other trading instruments. Of course, interest is payable on the margin as with any other form of finance, but the facility nonetheless provides a cost effective way to gear up your trading performance.

CFDs Offer Preferential Tax Treatment

In addition to this in-built ability to leverage positions, CFDs also come with the added bonus of a more favourable tax treatment in the UK. Unlike trading in shares, contracts for difference attract no stamp duty tax liability, saving potentially considerable amounts on the cost of the transaction. Unfortunately, CFDs do attract capital gains tax as with other instruments, although these are exempt from tax up to the annual CGT exemption amount, which is at present roughly $10,000 per person.

Furthermore, CFDs have no expiry date or enforced execution date. This means the only thing prohibiting vastly long term positions is the costs of financing, and provided on the rate of growth in the value of the CFDs you hold, it may prove lucrative to hold on to positions over the longer term and absorb the associated costs in order to reap a much more significant profit down the line.

Contracts For Difference Offer a Wide Range of Options

For more serious, professional traders, CFDs also provide an added layer of flexibility that provides an excellent hedge against losses and can factor in as part of a successful trading strategy. Because CFDs lock in a set price point, whether long or short, on a margined basis, traders can devise paired position to offset each other, with a view to profiting on whichever direction the market happens to move. Hedge funds in particular, as the name would imply, use hedging strategies as par for the course, and likewise a wealth of private traders use CFDs to act as their hedge against unexpected market movements.

Another often overlooked advantage that CFDs have, stemming from the fact they are taxable to CGT in times of profit, is that losses can be rolled over to be offset against capital gains made in future years. Essentially, that means any losses incurred in your early trading days can be applied against future profits, along with your annual exemption amount, to reduce the portion of your gains on which you have to pay income. Added to that the lack of applicable stamp duty, and CFDs start to appear to have more of an edge about them as far as taxation is concerned.

CFDs aren’t yet widely traded by individual, private CFD traders, as a result of a widespread ignorance as to what they are, how they work and the benefits they can bring. Luckily, the markets are becoming increasingly more familiar with CFDs as time goes on, and an ever-growing number of traders are turning their attention to CFDs as part of a wider, diverse trading strategy.

Contracts for difference are being traded in increasing volumes by traders from all walks of life, as a versatile, dynamic trading product with plenty of profit potential. One of the fastest growing instruments by trade volume, CFDs have been the focus of more than their fair share of column inches in recent years, with the financial press going nuts for what is, on the face of things, a very attractive retail investment product. So what is it about CFDs that make them different, and what in particular renders them a standout investment product? Furthermore, why should you consider trading CFDs as part of your wider portfolio, and how can you go about integrating CFDs into your trading style?

CFDs Bring Leverage

CFDs as an instrument appeal to institutional and retail investors alike for the flexibility and potential yield. While the benefits of trading CFDs are multifaceted, the starting point always has to be leverage, and the impact leverage can have on your trading fortunes. Indeed, if you were to ask a hundred traders why they choose CFDs as an instrument, you’d hear leverage as by far the most common answer. CFDs are by their very nature heavily leveraged, which means transaction sizes are artificially inflated to deliver larger returns. Traders cover a minimum required amount, known as margin, and the rest is notionally made up by the broker to facilitate a position often up to 20 times larger than the trader’s available capital resources.

Leverage works much like the gears in a car – in fact, so much so, that it is also known as ‘gearing’. Suppose a trader has $100 to invest. He could choose to buy $100 in shares, or he could choose to buy $100 in CFDs – even in like for like markets, the $100 will buy more CFDs than shares directly, and the returns from the CFD trade would outstrip the returns from the share trade many times over. For example, with a margin requirement of 20%, the $100 would actually buy $5000 worth of CFD exposure. This larger transaction size means that gains (and losses) are amplified, so effectively serves to up the ante when it comes to the amounts of money you can earn and lose from trading.

CFD Trading Offers Flexibility

Another key advantage and core reason why many traders are now choosing to invest through CFDs is the flexibility they offer over other, like instruments. CFDs can be taken both long and short, can be opened and closed relatively quickly, and are as a resultant particularly useful in hedging and portfolio building. Essentially, CFDs can do whatever you need them to do, allowing you to profit from both the upside and the downside of certain markets. And, of course, all with the help of handsome leverage weighing in to increase the gains you can expect to realise.

As if this wasn’t enough, and you needed even more reason to consider CFDs, they are also a tax-efficient instrument when compared to many others, particular share dealing, with a stamp duty exemption limiting the tax bill and having a not insubstantial effect for frequent traders.

CFDs are generally considered a vital tool in the modern trader’s toolbox, and having them at your disposal definitely presents a range of advantages. Whether you’re a new trader looking to get stuck in to the markets for the first time, or you’re a trader with a bit more experience looking at diversifying your trading base, CFDs can be the perfect instrument for further consideration.

Contracts for difference were, until reasonably recently, considered something of a background product as far as the consumer investment market was concerned. The CFD trader was an unusual breed, and the demand for CFD trading at a private level simply wasn’t large enough to merit many column inches in the financial press. Fast-forward to today and the situation couldn’t be more different. CFDs have become a heavily traded instrument amongst traders of all sizes, including many substantial funds and institutional investors, who can see the merit in investing in products with significant yield potential.

As the barriers to trading CFDs have steadily been broken down, so too has the level of interest in CFDs as a basis for trading increased. As a result, CFDs are now widely traded by a variety of different classifications of organisation.

Private Investors and Traders

Contracts for difference are traded widely amongst private investors (thus CFD traders), and the level of growth in this sector in particular over the first part of the 21st century has been remarkable. Private investors are drawn into CFDs for a number of reasons, not least because of the significant earnings potential that they hold. Furthermore, Contracts For Difference make it more straightforward for CFD traders to take wider market positions, given the greater degree of flexibility they have as an instrument, and depending on the exact range of CFDs offered by your broker, the value of this in terms of potential trading diversity is significant.

As the financial media latched on to the growing interest and demand for CFDs and other similar products, the exposure led to CFD brokers starting to be more liberal in the markets they offer, and as a result of their marketing efforts private investors the world over are now directly engaged with positions in CFD markets.

Hedge Funds

Hedge funds were arguably the original and most fervent supporters and traders of CFDs, and have for many years been actively involved in the trade of CFDs. Structured to appeal more directly to high-yield investment opportunities, hedge funds are perhaps the natural vehicle for CFD trading, and have taken full advantage of the opportunities posed by the CFD markets. And with millions and potentially billions under management for most hedge funds, the scope of their buying power and influence on market direction is significant.

Institutional Investors

Similarly, institutional investors like large banks, funds and insurance companies are involved in the trade of CFDs, as part of their profit-pulling high-risk exposure investments. While, of course, CFDs pose a significant threat to capital reserves, they also pose significant opportunities, particularly for large-scale investments, which means that even subtle price movements can result in massive earnings. For this reason, institutional investors may be more inclined to adopt a short-term outlook with CFDs, to avoid incurring the additional costs of financing and to take full advantage of the tax-efficiency (particularly over transacting in shares).

CFDs are not traded strictly by any one class of investor more than the other, but it would be fair to say they have experienced something of a resurgence of late – a rebirth, in the eyes of the consumer investment market, which has resulted in them being a highly valued instrument and a vital component of many. CFD Traders are finally on the rise once again.

Aside from the two main order types, which present traders with a mechanism for automatically closing out on their open positions at certain times, brokers tend also to offer a number of ancillary, more advanced orders which can be used to help add greater flexibility to the trading portfolio. Three such orders are the so-called ‘if done’ order, the ‘market’ order and the OCO (One Cancels the Other) order, all three of which give traders the ability to create formula for the execution of certain trading commands and instructions.

How Does an ‘If Done’ Order Work?

An If Done order is effectively an instruction to perform a certain trading activity once a certain criteria is met, such as an asset reaching a certain price point. For example, if you have a buy order set at a certain lower limit and the market falls to reach that limit you’ve specified, If Done orders can be used to set up the stops infrastructure around your new position – all automated, with no fuss, and no need to be chained to your trading desk.

This has the obvious advantage of allowing the trader to concentrate on other things, such as analysing other markets and keeping abreast of current economic and financial developments. By using If Done orders to carry out all the relevant trading instructions, the process becomes much more streamlined for the trader, and even permits the trader to set up a range of different trading outcomes, depending on how the markets move, to leverage those movements.

How Does a ‘Market Order’ Work?

Distinct from an If Done Order, a Market Order is a trading instruction to enter a position, either long or short, at the next available opportunity. Usually, this is implemented over the course of a trading day, but it can also oftentimes be applied during non-trading hours to capitalise on the market’s opening flurry. Market Orders specify that the broker should execute as soon as possible on the most favourable terms available at that point, and automate the process of getting in a market early.

How Does an ‘OCO’ Order Work?

OCOs, or ‘one cancels the other’ orders provide a similar function to If Done orders, only that they are two separate orders that are more intrinsically linked. These most regularly take the form of a limit/loss pairing, set either side of a price point to either close at a loss or lock in at a profit, with the first to be triggered cancelling the other as the name would imply. This effectively puts the trader in a position where execution is almost entirely hands free, and both profits and losses from individual positions will be dealt with appropriately through the formula programmed in ahead of time.

The vast majority of new traders have very little idea as to how they can use more advanced stops and orders to their trading advantage. That means it’s worth dedicating the time to researching and learning more about how these can work for your trading portfolio, in order to gain a valuable edge over the competition. Added to that, the flexibility, efficiency and formulaic approach facilitated by more complex orders makes them a more than worthwhile component of a successful trading strategy.

Stop Loss Order

Perhaps the most common of all orders, and the one most familiar to new traders is the stop loss. An automated instruction to reverse an open position at a certain point, stop losses are usually an added extra with trading platforms, but the role they provide can be absolutely crucial in minimising your exposure to risk and freeing up your time to invest your remaining capital in other positions without the need to keep a constant eye on the performance of every single one of your positions.

Envisage running a trading portfolio with several hundred contracts for difference open at any one time. Positions would constantly by ticking – some up, some down – and you would be required to keep an eye on those positions that are losing you money so you can close them out as quickly as possible.

In the meantime, you’d be required to keep abreast of the latest developments affecting your industries and sectors, while also identifying trends, analysing performance data and making tactical decisions based on your findings. Without stretching the imagination too much, it becomes quite easy to see the logistical nightmare which can present itself with even moderately sized trading portfolios.

Where the stop loss comes in is in minimising the losses of any one position, and in automating the process of cutting out of positions when they reach a certain point below the value at which the contract was opened. In essence, a stop loss is an instruction to reverse a trade when it hits a certain trigger point, usually below which your CFD would start to incur more significant liability from your trading portfolio.

Because CFDs usually attract unlimited liability for losing positions, and brokers have an enforceable contractual right to collect monies owed to them as a result of unpaid margin calls, it’s vital that you take every available step to prevent losing fortunes on positions that don’t go your way, and the stop loss is the number one way of preventing that from happening.

A Short Example of Using Stop Loss and Stop Limit

A good rule of thumb with a stop loss is to set it on or just below the recent low point of the underlying asset’s price. Say Company X securities haven’t fallen below $1.00 in the last 6 months, and are currently sitting at $1.10 – you might choose set a stop loss at $0.99, assuming that if the price hit this new low it may be moving into unchartered territory and may not recover to recoup your liability. At the same time, a trader might want to be happy to close at $1.50 so stop limit order will collect the profit the moment the price of Company X hits the target.

Of course, you intend for the position to perform well over time even if it ticks downwards on a few occasions over the duration of its open period – so it’s important not to set the stop at $1.09, otherwise the transaction will prematurely close and you’ll foot the costs of the trading commission and financing and lose money on an otherwise promising trade. With stop loss orders, it’s about finding the right balance between risk minimisation and allowing the natural cycles of asset price movement freedom to breathe.

In Essence: Stop Loss Order is used to limit your losses when the market moves against you.

Stop Limit Order

Of course, a stop loss is only a useful tool for minimising liability in long positions with CFDs. Taking a short position on a particular contract will leave you requiring a different type of order to close out and minimise your losses – known as a stop limit. Stop limits perform the exact same function as stop losses, only that they sit above the current share price, and they can be used as a means of securing a certain level of profit from a long trade as well as handling exposure to risk.

In Essence: Stop Limit Order is used to collect a profit when your profit target is hit.

Applying Stop Loss and Stop Limit

Both stop losses and stop limits can be applied to long and short positions, but their effect in either maximising revenue or minimising profit is reversed depending on whether you’re going long or short. Obviously when limiting your profit that can have drawbacks, but providing the order is set at the right level it can be a great way to cash out at the top before the underlying asset price heads south.

Stop losses and stop limits play a crucial role in any trading portfolio, and are an essential part of the successful forex and CFD trader’s arsenal. Whether it’s on the upside or the downside, orders take out much of the hassle from maintaining your open positions, and provide a guaranteed get out point when certain trades don’t go your way.