What Are The Risks Of CFD Trading?

You've probably read about the risks of trading. Having heard stories of scams, losses, and failure, many a potential trader agonises over whether to open a trading account or not. 

While there are scams, losses, and failure; scams are far from the norm, losses are simply a business expense, and failure only comes to those who do not prepare wisely.

If you approach trading in a structured, methodical manner, CFD or Forex trading is actually less risky than most standard business ventures.

If you drive a car for the on the motorway, without ever having had any instruction, you'd agree it isn't going to be pretty is it?

Well, this is exactly how most approach the business of trading.

The purpose of this blog is to help the beginner navigate the early part of the learning curve, which is always the most dangerous part.

There are risks in trading, but it's our job to manage them wisely.

This post lists the main dangers, and how to reduce them significantly. 

Bankruptcy risks

Client money risk. A broker can choose to run off with our money. All client's monies legally need to be separated from a broker's own business accounts.

Regulators do their best to protect the consumer, but there will always be a small risk.

Counterparty risk. Assuming you've done your due diligence, and your broker is financially sound; there will always still be a chance that some financial institution goes under, taking your broker with it.

This happened during the financial crisis of 2008, as many large firms that went under, had contracts, or obligations with other firms. This led to a domino effect, with firms such as Lehmans, Bear Stearns, Northern Rock, and AIG going under.

Ironically, the so-called, 'risky' CFD and Forex providers were immune, whilst many 'respectable' banks went bankrupt, through the belief that house prices would go up for eternity.

Market Risk

Random news risk. Shock announcements are part and parcel of the markets. The vast majority of the time even shock events won't affect your trading account. But there are occasional outliers.

In all my years of trading (2003), there has only been one black swan event that I was ever concerned about.

Gap risk. This is actually linked to the previous one. On shock news events markets can gap. The bigger the shock the bigger the gap.

The 'Brexit' gap was one such event.

If you had been long the GBP, or the stock market as the result came in, it would have hurt big time. But as risk managers, we know the calendar of important news events beforehand.

While the outcome of the Brexit referendum was not expected, the date of it was known over a year in advance; having a position (long or short) going into this day would have been foolish.

A losing trade. Despite our efforts, we can NEVER control when a trade is going to win or lose. All we can do is use a system that puts the probability of a successful outcome in our favour.

Psychological risk

Self-discipline. This is the risk of not sticking to your profitable trading strategy during a losing phase.

Refusing to take a loss. New traders are often uncomfortable losing money on a trade and therefore let small losses get out of hand.

Closing a winning trade too early. New traders are uncomfortable with winners, closing them out too soon for fear of losing what they have got.

The Risks of CFD Trading

Due diligence.

Some of the risks of trading our beyond our control.

We never know if a broker will go bust, or whether some shady CEO will abscond with our trading stake.

But, even uncontrollable risks can be reduced through due diligence. 

We need to know the broker we are choosing is reliable, trustworthy.

This might mean going over their financial statements.

It could mean researching opinions and views of those who've used their services. Or choosing a broker that is quoted on the stock exchange.

It means having a preference for brokers who do business in a stricter regulatory jurisdiction; and also keeping up to date with news flow affecting the industry. 

None of the above is the most riveting way to spend days, but they're all part of being a trader.

Money management.

Traders are not in the business of predicting markets despite what many people think. We can never predict the direction of markets with accuracy.

All we can do is employ our trading edge on a consistent basis. Simple pattern trading is one of the best way to do this.

Part of developing a strategy involves money or risk management.

This involves:

Position sizing. This is how much you risk on any one trade.

Protective stop. This is where you if you are wrong.

Exit strategy. This is where you exit if you are right.

It is these three that will reduce the market risks that you face. 

 

Final Thoughts 

CFD and Forex trading are considered risky, but there is a sliding scale of risk. With some highly unlikely, others more likely but within your own locus of control.

Regulatory risks involve aspects of the law. Including safety of clients funds and risk that counterparties can default having a knock-on effect at your brokerage.

To a large extent, these are managed through the financial regulators that govern the Forex, CFD, and banking industries.

With your own due diligence, these risks can be reduced further.

Then there are market risks.

These are part and parcel of trading. It can be unexpected news, corporate, or geopolitical.

Such events can lead to gap risk, meaning you don't get the correct protection from your stop-loss.

Or, it could simply mean your system experiences a loser, for no specific reason beyond a random distribution of winners and losers.

Finally, we have psychological risk.

This is the most common, but also the hardest for inexperienced traders to manage.

It includes a range of self-discipline related issues, from not following your strategy rules, to letting losses get out of hand, and not letting winners run.

As traders, it's our jobs to manage all of the above. The extent to which we do determines how successful we are in this business.

 

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John Scott
John Scott has been trading CFDs and FX since 2003. His favourite markets are the Dow 30, Gold and the GBP/USD. John believes short-term price action trading is the best approach for beginners to trade. Tradeneophytes is his humble attempt at helping new traders reduce the learning curve to trading success.
Posted in Beginner Trading Guides.

John Scott has been trading CFDs and FX since 2003. His favourite markets are the Dow 30, Gold and the GBP/USD. John believes short-term price action trading is the best approach for beginners to trade. Tradeneophytes is his humble attempt at helping new traders reduce the learning curve to trading success.

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