What are the risks of trading CFDs?
While there are many potential benefits to trading CFDs, it is worth noting some of the potential risks associated with trading leveraged financial products.
Potential to lose your entire investment
Leveraged trading can be seen as a double-edged sword. This is because although you can maximise potential profits, potential losses will also be magnified. This means that you could lose your entire investment if the trade goes against you, if you are a Retail Client. Professional clients can lose more than their deposits and they may be required to deposit additional funds to cover their losses. That’s why it is important to incorporate risk management tools into your positions, to make sure you are not exposing yourself to unnecessary levels of risk. It is also important to make sure your account is adequately funded to prevent unwanted stop-outs.
Overnight charges
Positions held overnight are subject to what is called an ‘overnight financing’ charge. This cost is incurred on a daily basis, which means the longer you hold your CFD trades open for, the more financing costs you incur. The financing charge is linked to the interest rate of the underlying asset. Essentially the charge is an interest payment to cover the cost of the leverage that you use overnight.
Margin call/Close out
If you have open losing positions and you do not have enough equity to cover those positions, your trading account will become at risk of margin close-out. You should continue to monitor your trading account to make sure you have enough funds to cover the total margin requirements for your open trades, as well as some consideration for market volatility, at all times. This will ensure you don’t receive an unwanted margin call, which will result in all or some of your positions being automatically closed out once your equity falls to 50% of your margin requirement.
Slippage Risk
Slippage is essentially when the price your market order is filled at, differs from the price you requested. This can work in your favour (‘positive slippage’) or against your (known as ‘negative slippage’). It can occur in fast-moving market conditions or in markets where there is a lack of liquidity. During these volatile market conditions, you will not always have your market order filled at the requested price.
Non-Guaranteed Stop Losses
A normal stop loss order does not 100% guarantee you will be filled at the particular market price you set your stop level at. This may be because of ‘Slippage’ which is based on two factors, liquidity and volatility.
Gap Risk
There is often a risk holding positions open during closed market periods. In forex, your closed market periods would be over the weekend, between 10.00pm on Friday and 10.00pm on Sunday. If, during the weekend there is any data release, large news event or geopolitical event (such as a political election), this could cause Friday’s closing price to differ significantly to the first price on the Sunday open. This is known as ‘gap risk’. Gap risk can affect your open trades, should you be trading an instrument impacted by the news event. This can work both for and against the trade, depending on your position in the market.
For example: Let’s assume you have a long position in GBPUSD, with an entry price of 1.30, a stop-loss set at 1.29 and a take profit set at 1.31.
Scenario 1: The news event negatively impacts sterling (GBP)
GBPUSD opens at 1.28. This will trigger your stop-loss and you will be filled at the best available price. Although this is at a worse level (of 1.28 despite stop-loss set at 1.29), this is the first available price for you to exit your trade, and your losses may be larger than you had initially anticipated.
Scenario 2: The news event positively impacts sterling (GBP)
GBPUSD opens at 1.32. This will trigger your take profit and again you will be filled at the best available price. However, in this case, it is to your advantage, with you receiving a far larger profit on the trade than you would have originally anticipated.
If you are new to trading CFDs, it is important you understand exactly what margin and leveraged trading is. This is explained in detail in our next guide.
