CFD is an acronym for Contract for Difference, a derivative financial instrument that has become increasingly popular amongst investors. They allow the investor to buy and sell assets without having to own them outright. Since its development in the 1970s, its use has been growing fast. From being traded only between banks and other institutions, now individuals can partake too.
The potential dangers of investing in these products were laid bare since the 2008 recession/credit crunch, raising serious questions over whether this product should be routinely offered to retail investors by brokers.
Why Do Brokers Scrutinize CFDs?
At present, regulators monitor investment firms closely because there have been indications that problems may lie within their sales. In comparison, there is nothing inherently wrong with these products, the fact that they are such speculative means that they can quickly get out of hand and lead to significant losses. CFDs permit investors to open trades on margin (i.e. using borrowed money). When used responsibly, this can boost returns, but many brokers have seen clients lose thousands in a matter of hours when misused.
It was evident in Britain during the financial crisis back in 2008; while some grew wealthier thanks to their investments in these products, others lost millions and were left. The problem here is that while traditional forms of trading protect both sides of an arrangement by ensuring that all parties gain something themselves, CFDs do not guarantee such an arrangement, removing the brokers’ obligation to be fair. It’s because they allow clients to set up a large number of trades and then wait for them to ‘expire’, which allows them to collect whatever gains they manage to make before their losses come into effect.
As more and more people became exposed to this form of trading, the volume of complaints grew. Eventually, Britain’s Financial Services Authority (FSA) noticed and stated that it would begin probing investment firms who were found advertising CFDs prominently on their websites. They warned that any firm offering these products must explain how margin trading works and provide information about the potential risks.
The Growing Dangers
CFDs carry several risks because these kinds of financial instruments allow investors to speculate on rising and falling markets; rather than exchanging assets directly. For instance, if someone were to buy 100 shares in Apple, they would receive dividends along with physical ownership of the firm’s assets. But if they bought CFDs instead, there is no guarantee that they will be paid out when their contract expires – simply because this is not how these products work. Buyers bear all the risk involved, which can quickly lead to huge losses for those who don’t fully understand what they’re doing. Because margins are set so close to each other by brokers—there are few breathing spaces between them.
Of course, there is a reason why CFDs are so popular: their prices change according to fluctuations in the market itself. The ability to track how they’re performing at any time has led many people to believe that they can predict where the asset will go and then invest accordingly. Have a look at the Saxo markets for more information on this.
Investors can buy shares when they think their price will rise or sell when they think it will fall. The problem here is what many brokers fail to mention. If you decide not to trade your CFD immediately after purchasing it but wait until later on, chances are you won’t be able to set up a similar deal again, even though the stock is still trading on the market.
CFDs are seen as excellent opportunities for those who want to invest in the markets and potentially make a lot of money. Because their prices fluctuate according to what happens in the real world, investors can take advantage of this by deciding when they think an asset will peak – allowing them to sell before it starts going down again.
However, because these products don’t give clients direct ownership over assets and force them to pay out whenever they expire – brokers need to clearly outline potential risks involved and ensure that the terms and conditions cover all possible scenarios.