Some would argue that trading Contracts for Difference (CFDs) is no different to gambling and you are throwing good money after bad, but this isn’t true. Yes, CFD trading can be risky, but then so is forex and other stock market trading. No form of trading is risk-free, but with the right strategies in place, you can minimize your losses and maximize your gains.
Trading is risky when you don’t understand how the markets work. You wouldn’t offer to fly an Airbus 380 without any previous flying experience because it would end in disaster, yet plenty of inexperienced traders jump in feet first and start trading CFDs. Not surprisingly, because this is a leveraged product, they lose their shirts, their pants, and a lot more besides.
CFDs are Banned in the US
To make matters worse, CFD trading is banned in the US and several other countries. CFDs and other high-risk investment options are now subject to restrictions in Europe too. The European Securities and Markets Authority (ESMA) introduced new rules this year and the marketing, distribution, and sales of CFDs to retail customers are now restricted. Customers will see a specific risk warning, providers can no longer use incentives to market their products, limits apply to leveraged opening positions, and negative account balances are protected on a per account basis.
EU Regulatory Crackdown on CFD Trading
In the UK, CFDs are under close scrutiny. In a statement published in March, the Financial Conduct Authority (FCA) publicly supported the ESMA measures. It has since raised concerns that firms are seeking to circumvent the new rules by offering alternative and equally high-risk speculative products.
In a statement, the FCA said: “ESMA’s intervention is focused on CFDs, but we remind firms of their existing obligations. In particular, if a firm is considering marketing, selling or distributing alternative products, it should pay attention to conduct of business requirements. These include rules on the client’s best interests, communications with clients and financial promotions, and suitability and appropriateness. We also expect firms to consider carefully whether they can satisfy their relevant product governance obligations.”
A Leveraged Product
The main issue with CFDs and other high-risk investment vehicles is that they are a leveraged product. Losses can wildly exceed the cost of the original investment when a product is leveraged at 30:1. For example, you could have £5,000 in your trading account, but thanks to the powers of leverage, you could trade £150,000 worth of shares. If your losses exceed the balance of your trading account, you are in trouble.
It’s important to realize this from the very beginning. Yet CFDs can be very profitable if you approach them in the right way. They allow you to trade many global financial instruments without owning the underlying asset – there are many resources for those who would like to learn more about CFD trading.
Professional traders understand the risks and capitalize on them to make money. The key is controlling leverages, using stop losses without exception, and trading with caution. If you use CFDs as part of a wider trading strategy, you can make a series of small but significant profits and improve your trading account balance.
CFD Trading Strategies for Success
- Always cut your losses – stop losses are there to protect your trading account. Use them.
- Limit your exposure – never trade more than 2% of your capital. This minimizes your losses and ensures you don’t wipe out your entire trading account.
- Don’t let emotion get the better of you – emotional trading is a recipe for disaster. Successful traders use logic not emotion when they trade. Ignore your gut feelings and concentrate on data analysis instead.
- Maintain a diverse portfolio so if one industry tanks, another should pick up the slack.
- Don’t chase losses – if a trade is losing, adding to it won’t help. Follow trend lines and use them to guide your trading decisions.
- In the wrong hands, CFDs are no different to blowing your life savings on the roulette table. In fact, roulette is arguably safer as it isn’t leveraged – you may lose all your money, but at least the casino won’t be chasing you for even more.
- Use technical and fundamental analysis to educate your trading decisions.
If you do decide to trade CFDs, make sure you fully understand the risks involved.
Sources: fca.org.uk / standard.co.uk