A Contract for Difference (CFD) is not the best option for every investor, as CDFs are traded on margin and incorporate a higher risk level. One of the most basic trading rules is that you should only trade money that you can afford to lose, and it is very important to understand the risks involved with trading CFDs prior to making that first trade in order to minimize losses and maximize gains. Traders sometimes rush to trade CFDs after reading the advantages without fully understanding the potential risks, leading to bad trades, negative margin calls, and sometimes even financial disaster.

Learn about the risks before jeopardizing your hard-earned money:

Leverage Risk

CFDs are traded on margin, and this means increased risk due to the leverage involved in this type of trade. Even a small movement can lead to catastrophic losses in a very short time frame—losses even greater than the initial investment in the trade. In the same way that gains can be windfalls with leverage trades, losses can be devastating.

Big losses are just as likely as big gains when making leverage trades.

Investment Market Risk

Investment market risk is the risk inherent to the market, since when the trader is buying shares, indices, commodities, or other CFD derivatives, he or she anticipates that the asset value will increase so that it can be sold for profit. Conversely, traders anticipate that the value of the product will drop after that product is sold, meaning that the trade was a good one for that individual trader. Keep in mind, however, that even expert traders can be wrong when they predict the market due to unexpected events that can suddenly affect the market in unforeseen ways. From governmental coups to natural disasters, drastic market-value changes can instantly mean massive, career-ending losses.

Even the experts can make mistakes when it comes to trying to predict the market, and one wrong CFD trading prediction can spell financial disaster.

Liquidity Risk

Liquidity is one of the biggest and most important risks to consider when trading in the financial market. When there are few trades being placed or not enough trades being offered, the lack of liquidity can be just as damaging as high-volume liquidity can be, as it makes it more difficult to trade those CFDs. This can lead to an inability to buy and sell at requested prices.

Low liquidity can be just as dangerous as high-volume trading as it may mean that there are no traders/opportunities to buy and sell at the shown price.

Counter party Risk

Another common problem occurs with counter parties, especially if they refuse to fulfill a financial obligation to another trader. Over-the-counter (OTC) CFDs are provided based on financial arrangements with providers, impacting a trader’s daily activity when even one provider declares bankruptcy or other financial disasters occur. Individual traders can lose everything in these situations, even if the market is fluctuating in favor of that trader. Make sure to choose a licensed, certified CFD broker and do not give the entire investment portfolio to one broker as this minimizes risk and avoids overexposure with one brokerage firm.

As the old saying goes, traders should avoid putting all their eggs into one basket by spreading their portfolios across different brokers.

Portfolio Risk

One rule of thumb to follow is to be sure that the broker always segregates trading portfolios from the broker’s personal portfolio, protecting the trader’s money in a completely separate trust account. Check local and federal laws regarding CFD regulations, including how client money is handled. Never blindly trust that a broker will follow these laws; always work with a licensed, certified professional.

Traders should never trust a broker without determining his or her suitability and professionalism when handling accounts.

Gapping Risk

“Gapping” occurs when the market price fluctuates rapidly from one price to a significantly different one, bypassing one or more price levels. For example, the price of a CFD could rise from $10.50 to $21.10 without trading at any price in between. However, the opposite is also true, and the price could plummet from $21.10 to $10.50 without any stop in the middle range. There are many causes for gapping, like economic and company financial announcements, political events, and other unexpected or unpredicted situation.

Gaping is when market price moves rapidly from one price to another, skipping various prices in between. Gapping occurs mainly due to low volatility and news announcements.

Technical or Unplanned Risk

Certain market conditions might prevent a CFD provider from executing trade orders, some of which are simply beyond his or her—or the trader’s—control, but which significantly affect that trader’s bottom line. Some examples of these conditions include system errors and outages, Internet connectivity issues, scheduled or unscheduled maintenance periods, and/or failures of third parties—including Internet service providers and electric companies. These technical risks may pose significant risks to the trader’s ability to transact business, since a lack of electricity or Internet service makes it impossible to trade, regardless of market conditions.

Traders can’t plan for some risks, such as power outages, Internet-connection issues, maintenance outages, and so on.

Bottom Line

CFD trading carries a high level of risk, and it is not suitable for all investors. Understanding these risks is very important before trading real money in the markets in order to minimize any risks and reduce potential losses. Everything from unscrupulous brokers to gapping to technical problems can affect a trader’s day, so it is important to know what to do in case these situations arise and you have to protect your investments. Know what risks are inherent before making that first live CFD trade and have a backup plan ready in case something goes wrong. Trade smart and earn big!

Summary

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Big losses are just as likely as big gains when making leverage trades.


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Even the experts can make mistakes when it comes to trying to predict the market, and one wrong CFD trading prediction can spell financial disaster if you don´t know what you are doing.


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Low liquidity can be just as dangerous as high-volume trading as it may mean that there are no traders/opportunities to buy and sell at the shown price.


P

As the old saying goes, traders should avoid putting all their eggs into one basket by spreading their portfolios across different brokers.


P

Traders should never trust a broker without determining his or her suitability and professionalism when handling accounts.


P

Gaping is when market price moves rapidly from one price to another, skipping various prices in between. Gapping occurs mainly due to low volatility and news announcements.


P

Traders can’t plan for some risks, such as power outages, Internet-connection issues, maintenance outages, and so on.


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