Taking note of the fact that in its recent opinion on MiFID practices for firms selling complex products, ESMA classes Contracts for Difference as an example of such complex financial products that merit extra caution and also taking note of a recent paper circulated by the Cypriot regulator, CySEC, which lists the inherent risks of CFD trading, we revisit the issue once more in an attempt to provide potential CFD investors with a clear outlook on what CFDs actually entail.
Let us first remind those in the know and enlighten the ignorant that Contracts for Difference, or CFDs for short, are essentially and as their name implies, a kind of an agreement between two parties to exchange the difference between the current price of an underlying asset and its price on the day the agreement expires. As CFDs are available in many forms, this underlying asset can fall within any of the four major assets categories, i.e. it can be a commodity, or stock shares, or currencies or even indices. The actual profit or loss resulting from the said agreement is calculated upon the expiration of the contract through the multiplication of the difference between these two prices with the number of CFDs invested in.
As CySEC eloquently mentions in its aforementioned paper “CFDs are leveraged products, enabling investors to make transactions with only a small margin (deposit). However, although CFDs might look similar to more traditional investments, such as shares, in reality they are very different and far more complex. Due to their complicated structures and the high level of risk they carry, CFDs are considered by the financial supervisory authorities as being suitable only for professional clients or highly experienced retail investors who can understand how they work and the risks they entail.”
It becomes evident then that CFDs carry with them increased risks to which potential investors are exposed when choosing to carry out a CFD transaction. The primary reason for this is the lack of standardization associated with other types of financial products. Because this does not apply when it comes to CFDs, each investment firm offering CFDs has the opportunity and flexibility to apply not only different charges but also different terms governing its agreement with the investor. The greatest danger here is that it is rendered extremely complex and difficult for an investor to be able to accurately calculate the cost for every given trade. In turn, this means that the potential profit might well be outweighed by the actual cost.
It goes without saying that highly leveraged CFDs are far riskier, because just as how leverage can magnify the potential profit from a trade, it also correspondingly magnifies the potential losses. Thus, aiming for too much could leave you with much less.
Another important factor to consider prior to investing in CFDs is the associated liquidity risk which might result in the investor losing more money than the sum of their initial capital investment, especially since there are no fully effective ways of protecting investors from losses, because “stop loss” limits are often not adequate in this regard or are not implemented satisfactorily. This is the case because often in CFD trades the margin which is needed to be maintained by the investor is recalculated on a daily basis. This recalculation, takes place in accordance to the changes recorded in the value of the underlying asset which the CFD pertains to. In case there is a reduction in the price of the said asset, then the investor has to cover the negative balance and restore the margin position. In case the investor is unable or unwilling to commit the extra funds needed to cover the loss, the investment firm through which the CFD was entered into refrains the ability to close the position and also liquidate all the CFD positions of the investor, irrespective of the fact that the price of the underlying asset may subsequently recover and would have resulted in a profit at a later stage.
CySEC, in its paper, as well as other regulatory authorities draw attention to the fact that often the companies offering trading in CFDs advertise the potential profits without adequately explaining or highlighting the risks to the investors and in this way end up misleading them.
In the light of all the associated risks and dangers involved, regulators therefore advise investors to only choose to invest in CFDs provided they completely understand the product that is on offer and preferably only if they already possess extensive experience in trading in CFDs, ensuring in this way that they fully appreciate the risks involved. Another prerequisite for successfully trading and investing in CFDs is for investors having enough time to monitor their investment very frequently, as the very nature of this particular investment vehicle demands that.
Finally, potential CFD investors are urged, prior to entering a Contract for Difference with an investment firm, to safeguard that they have a clear picture on the particular costs associated with trading CFD with the specific firm. Moreover, they need to know how the firm determines the prices of the CFDs and whether it is prepared to disclose the margins it makes on the trades. Another important factor to examine is what exactly will happen in case the investment firm defaults and whether an investor or deposit protection scheme in place in the event of counterparty risk.
In short, if you are in any sort of doubt or something is unclear about exactly what is on offer, it is better to avoid CFD trading all together.