Forex and CFD Trading Risks

Forex and CFD trading risks

Forex and CFD trading can be speculative and involve significant losses.  This is because they are both leveraged products with prices that may move rapidly against you.  It is therefore fundamentally important to fully understand the risks involved for both types of investments before making any trading decisions.

Forex trading risks

1) No centralised market – unlike regulated futures exchanges, there is no central market place for Forex buyers or sellers therefore the price offered by different Forex dealers can vary.  When you are trading in the Forex market, you are relying on the dealer’s integrity for a fair deal.

2) Volatile market – the Forex market is volatile and currency prices can undergo adverse changes in any given trading period.  Fluctuations in the foreign exchange rate between the time you place the trade and the time you attempt to liquidate it, will affect the price of your Forex contract and the potential profit and losses relating to it. 

3) High leverage trading - high leverage trading may increase your profit but it can also increase your losses.  It is highly possibly to incur significant losses in margin trading. 

4) Credit accountability - when the deal is closed in a Forex transaction, there is a possibility that one of the parties may not honour the debt (for instance, when a financial institution declares insolvency). Nevertheless this risk can be minimised by dealing on exchanges that are regulated and require members' credit worthiness to be monitored.

5) Country risk - some governments (mainly those of minor currencies) may attempt to limit the flow of their currency to try and sway the Forex market.  In spite of this, country risk is not usually associated with major currencies.

CFD trading risks

1) Magnified returns magnified risk - while CFDs are potentially more rewarding than ordinary share dealing, this also means that the risks and potential losses can also be greater.  This is because CFDs are traded on margin and the leveraging effect of this can increase the risk significantly.  Margin rates are typically small and therefore a small amount of money can be used to hold a large position. 

2) Liquidation risk - when you take out a CFD, you will be asked for a deposit for that transaction which is typically around 10%.  CFDs can remain open as long as you want, and so the CFD must always have sufficient collateral support to cover potential losses.  If a CFD moves into a loss-making position, then a ‘margin call’ can be made where you will be asked for a deposit of additional funds to ensure that the CFD remains solvent.  In fast moving markets this may be at short notice and if funds are not provided in time, the positions may be closed / liquidated at a loss for which you may be liable.

3) Counterparty risk - if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD trader could potentially incur severe losses, even if the underlying instrument moves in the desired direction.

4) Interest - interest payments are required to support long positions that are held overnight. The rates tend to be more attractive than those for a typical high street personal loan. They are usually based on an interest rate at which Banks lend money to each other.

5) Shareholder privileges - with CFDs you do not actually own the shares so you do not receive all of the privileges normally associated with share ownership. However, you still have voting right and can attend Extraordinary and Annual General Meetings. When you use CFDs to trade shares or an equity index, you are still able to benefit from dividends when they are paid.

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