Potential Concerns with CFDs

CFDs Are Often Perceived as Unreal

Some of the concerns surrounding CFD trading are ones we want to be aware of, but some are just a product of a lack of fundamental understanding of the nature of CFDs. Thoughts that CFD contracts are fundamentally inferior due to traders not actually having any positions in securities falls into the misunderstood category.

If CFDs were not regulated and the brokers who you take these positions with could not be trusted to hold up their end of the bargain, then this would indeed be a concern, a monumental one even. We could then claim that holding the security would be a huge advantage and maybe even essential if the risk involved of the CFD broker defaulting or taking our money and running was high enough.

Potential Concerns with CFDsThe risk involved in the trade not being held up by a default of obligations is called counterparty risk, and there is always counterparty risk involved in everything of some degree. When you make a deposit at a bank there is counterparty risk involved because if the bank defaults you may not get your money.

Banks don’t hold your money in a vault, they lend it out, and if not enough of the loans get paid back, or if too many people want to take their money out of the bank, the bank will not be able to fulfill their end of the bargain. Banks count on this not happening, in other words people keeping their money on deposit, and when too many people don’t, called a bank run, this can spell death to the bank all by itself.

CFD brokers do keep your money in banks, so there’s that counterparty risk, but that’s no different than your keeping it in one, so that one is not pertinent. Due to this segregation, your money is safe unless the broker is a rogue and will violate the regulations here, which isn’t impossible although rare. This is why we should only be dealing with reputable CFD brokers.

It actually does not matter whether we actually own or hold positions in any securities, external ones that is, because the contracts with the CFD broker operate just as if we did, only with more efficiency. The great majority of financial trading does not involve actual securities being held, but are essentially just bets on things. CFD trading is therefore not fundamentally different from other derivatives such as futures, options, and swaps. They are all contracts between parties creating obligations based upon the movement of the price of another asset.

CFD Trading is Risky

CFD trading can indeed be risky, and this comes down to the amount of leverage you can use. Some brokers offer 500:1 or even 1000:1 leverage, and the risk involved in trading with this amount of leverage can be appropriately described as simply insane.

At 1000:1 for instance, a movement against you of only a tenth of a percentage point will wipe you out. The spread alone will have you pretty close to the wall right off the bat, so the move against you that will wipe out your position is even less than this. Further moves down will have you not only losing all your money but potentially owing many times more than that.

No one in their right mind would trade with that much leverage, although being in your right mind is not a requirement to trade CFDs. There are plenty of people who blow up their accounts or worse in short order by having no idea of the risks of extreme leverage.

There are some who claim that any leverage, even 2:1, is too risky, although this all depends on the strategy. If you are of the mind where you’re going to hold on to a position when it’s price drops off the table, even losing half its value, if it does and you are leveraged 2:1 you have lost all your money.

For traders though, 2:1 leverage is often seen as way too tame, and if you’re exiting positions when they move against you by small amounts, and you are a skilled trader, you can handle significantly more leverage than this. No one can handle amounts like 500:1 or more, or even close to that actually, because one must endure even small losses without significant damage, and with too much leverage, all losses can be too damaging.

Leverage is a powerful tool that can work both for you and against you, and having the ability to over leverage does not mean that traders need to do so. CFD trading is like driving a race car, there is a lot higher potential to crash it if you drive too fast and don’t have enough driving skill. The goal always needs to be to only go as fast as you can safely travel, and this depends very much on how good a driver you are.

We cannot nor should we look to prevent people from trading however they wish, and while it is required that CFD brokers make disclosures such as CFD trading involves high risk and you can lose substantially more than all the money in your account, the degree that people take heed is up to them.

In the end, while taking on way too much risk is a real concern, it is not something that cannot be managed, and well managed at that. Becoming a successful trader is no easy matter, it does require effort and commitment and discipline, and it especially requires a commitment to conduct oneself in a way that one will survive. Survival is the most important thing, by far, but a lot of traders don’t realize this and will take on way too much risk than is appropriate for their level of skill and experience.

So CFD trading can indeed be risky, but these risks can and indeed need to be managed properly. This may even mean that some traders may never get to the point where they are actually trading with real money, if they never get there, and trading with real money should be seen far less like playing the lottery and far more like something you graduate to once you’ve proven you can trade with simulated money.

There is no question that brokers are too aggressive in looking to push their clients toward real money trading, and that’s understandable given that they do not make money from simulated trades. Ultimately though, the obligation rests with the trader and not the broker to make these decisions.

CFD Trading is Gambling

Some people believe that, since no assets are bought and sold, CFD trading needs to be classified as a form of gambling, similar to casino games, poker, playing the lottery, sports betting, and so on.

Those who hold these beliefs also believe that gambling in itself is undesirable. While they are entitled to their beliefs, however strong, it is quite another matter to look to impose them upon others who do not agree. A lot of irrationality comes to the surface during these arguments, such as certain religious beliefs taking precedence over others, or the fact that if some people harm themselves by gambling than all people should be prohibited from it.

Whether or not one owns a security or just a contract it not a meaningful difference at all though. If someone buys a stock, if we define gambling as placing a bet on something, that’s exactly what the stock buyer is doing as well.

Seeing derivatives as gambling and by extension, undesirable, is something that the futures market has been dealing with since the early days of futures trading. It is only during the last few decades that futures trading has become widely believed as acceptable in the United States for instance, and for most of its history there were many in government who frowned upon it, especially those looking to speculate on it.

All derivatives contracts are pure bets in this sense, but measuring the so called purity of these bets is not done in a way that is any way that meaningful. If these bets are made to promote business success or not is not a meaningful distinction actually, and being in business itself involves placing bets, bets that the business will succeed and one will get a reasonable return on their investment.

The whole idea of something being more of a bet than something else is actually a distinction that does not have any real merit. Regardless though, why this would ever matter or even should matter is an even bigger question.

People speculate to various degrees on a great many things, and there’s certainly nothing wrong with speculation, it is necessary actually. If someone speculates on a stock or on a CFD trade essentially involves the same thing, a bet on the future price of something.

It really is all betting, but there’s nothing essentially wrong with that, as one is using one’s own money to at least seek to obtain some advantage. Whether one actually has an advantage or not isn’t the point, they may or may not, and there are always winners and losers, which is the nature of the game and the nature of life as well.

The United States still prohibits most CFD trading, although oddly enough, they do allow forex to be offered with CFD brokers. Forex trades perhaps don’t involve physical assets though, other than the money itself of course, so perhaps that’s the reason, although this probably has more to do with lobbying, not dissimilar to the lobbying that took down the bucket shops in the early 20th Century.

Many countries do offer their traders full access to the products that CFD brokers offer, which is pretty much anything that you ever wanted to trade and then some. Our minds do need to be minimally open to understand the true nature of financial markets, which is indeed a form of betting, although that’s not a bad thing and is actually a very good thing.

In the wrong hands, one may indeed harm oneself with financial trading, just like one can benefit oneself if one knows what one is doing enough. CFD trading does offer much higher potential for both gains and losses, and therefore needs to be approached with an appropriate level of caution, as higher risk requires better risk management.

Provided one can be successful in managing these risks, CFD trading offers traders some great opportunities to advance themselves. Perhaps more importantly, it offers traders opportunities to do whatever they want with their money, and if that means taking on too much risk, well ultimately,  it’s their money after all.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: andrew@marketreview.com

Areas of interest: News & updates from the Consumer Financial Protection Bureau, Trading, Cryptocurrency, Portfolio Management & more.