ASIC recently released a report detailing its review into difference (CFD) trading contracts. ASIC’s report found that most retail clients are not aware of all costs associated with CFD trading, particularly fees levied by financial service providers for opening or closing CFDs. Furthermore, CFDs expose retail traders to significant risks due to small margin requirements, resulting in outsized losses relative to capital invested.
The following article discusses strategies retail traders may use to reduce their risk exposure when CFD trading in Australia.
How do Contracts for Difference work?
A CFD is an agreement between two parties where one party agrees to pay the other if the closing price is more significant than its opening price. The difference in the opening and closing prices is called the “spread”, and it is this spread determines how much money each party makes or loses on a CFD trade. When an investor buys shares from another investor in traditional trading platforms, both parties will have to pay commission fees to their broker for brokering the transaction.
However, CFDs do not incur these same commissions because they are derivatives rather than equities. Furthermore, where a margin account holds a position overnight, it can result in additional interest being accrued by the counterparty who made the deposit.
Understanding the value of a CFD
Firstly understand that the value of a CFD will vary with changes in market conditions – especially price volatility – and those associated with counterparty risk, funding costs and broker/dealer levels. It means there may be times when you have little or nothing left from an investment if things don’t work out as planned.
In addition, payment for CFDs is usually made after the trade is executed. Suppose this happens at a time when prices have dropped significantly. In that case, it could result in significant losses incurred by investors who have paid out large sums of money without receiving anything in return.
Strategies for mitigating risk?
Take reasonable steps
ASIC expects brokers to “take reasonable steps” to ensure that retail clients receive ‘best execution’. An example of this is where a broker or market maker can provide negative balance protection, which will cover the trader’s losses up to an agreed level. This type of arrangement can benefit traders who wish to trade CFDs without fear of suffering heavy financial penalties due to significant margin calls.
Using stop-loss triggers
The Financial Markets Authority (FMA) recommends using trading platforms that allow you to specify stop-loss triggers for taking predefined actions when predefined price levels are reached. Traders should use these tools as part of their risk management strategy to minimise their capital risk and avoid unnecessary losses through large margin requirements.
Review commission rates charged
Traders should review the rates of commissions charged by their CFD broker, even though they are more likely to be compensated through spreads. A low commission rate can result in higher profits for traders because it reduces the amount of money paid out to their counterparty at the end of a trade.
Include risk warnings
The FMA guides using CFDs in New Zealand, including risk warnings and best execution obligations. For example, when trading CFDs, investors should avoid placing any part of their portfolio in risky asset classes (such as high yield or emerging market debt securities) because these instruments are often associated with volatile movements in price levels. Furthermore, if an investor does not have enough capital to trade these assets, they may avoid the need for additional margin deposits by trading CFDs.
Appropriate leverage levels
The FMA’s website also provides guidance on appropriate leverage levels for different types of investors, which should help retail traders understand whether they are comfortable with their level of risk exposure. For example, someone investing in an asset class through a CFD platform must be provided with guidance about appropriate leverage levels since it can result in heavy losses if not used correctly.
Check out these easy steps to develop your trading performance.