Overview
The third part of our blog series will focus on the risks associated with investing in CFDs. We all know that with great risk comes great reward – or great loss if you're not careful! So let's dive into the different types of risks you should be aware of, such as leverage, market volatility, and liquidity risks, as well as provide some guidance on margin calls. If you're considering CFD trading as an investment option, read on to learn more about the risks you should be aware of.
The Risks of CFD Trading to Retail Investors
CFD trading companies may take advantage of inexperienced traders in a variety of ways, including:
- High Leverage: CFD trading companies may offer high leverage ratios to inexperienced traders, which can amplify potential profits but also amplify potential losses. This can lead to traders taking on more risk than they can afford.
- Misleading Marketing: CFD trading companies may use marketing materials that overstate the potential profits and understate the risks of trading, which can lure inexperienced traders into a false sense of security.
- Complex Products: CFD trading companies may offer a wide range of complex products, such as options and futures, which can be difficult for inexperienced traders to understand and trade effectively.
- Poor Execution: CFD trading companies may execute trades at prices that are less favorable than the prices quoted to the trader, which can result in larger losses for the trader.
- Limited Educational Resources: CFD trading companies may not provide enough educational resources for inexperienced traders to understand the products and markets they are trading.
- Lack of Transparency: CFD trading companies may not be transparent about the fees they charge and the risks involved in trading, which can lead to traders being caught off guard by unexpected costs or losses.
Now that we have grasped the six main dangers to retail investors, let's look into margin calls more closely, a risk that applies to a variety of financial instruments.
Understanding Margin Calls: How They Can Destroy Your Portfolio
A margin call is a demand from a broker to an investor to deposit additional funds or securities into their margin account. This is in response to the value of the account falling below the minimum required by the broker. The purpose of a margin call is to reduce the risk of an investor's portfolio falling in value, as it is the broker who will have to make up any losses if the account falls to zero.
Initial margin is the amount of money required to open a new CFD position. This is a one-time payment that is necessary to initiate a trade. Maintenance margin is the minimum amount of money required to keep a CFD position open. This margin is a percentage of the total value of the open position and is necessary to ensure that the position can withstand adverse price movements. If the position value falls below the required maintenance margin, the position will be automatically closed by the broker.
It is important to be aware that your brokerage firm has the authority to decide when you must increase the amount of equity in your margin account. They may not contact you first and can take action without your knowledge if they feel the equity is too low and poses a risk to the account. This could mean that they can sell out any of the securities you own without taking into account the financial and tax implications for you.
Margin calls can be a major threat to the health of an investor's portfolio. If the investor does not have enough funds to meet the maintenance margin , the broker will close out the investor’s positions in order to protect their own interests. This means that the investor can lose all of their profits as well as any additional funds in the account. Investors should be mindful of the risks posed by margin calls and take steps to mitigate them. They should only invest money that they can afford to lose, monitor the value of their portfolio, maintain low leverage, and avoid taking too many risks.
In conclusion, CFD trading can be a high-risk investment option for retail traders, with dangers that include high leverage, misleading marketing, complex products, poor execution, limited educational resources, and lack of transparency. Additionally, margin calls can pose a significant threat to an investor's portfolio, as they can result in the loss of profits and funds if the investor does not have enough funds to meet the demand.
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Your investment can go up and down and you may get back less than invested. Carefully consider each product’s investment objectives and risk factors before investing. The above should not be considered as 1:1 financial advice.
