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Risk disclosure: the risks of trading contracts for difference

A contract for difference, or CFD, is a contract with a provider that settles the difference between an asset’s price when you open a trade and when you close it. CFDs are complex, leveraged instruments and come with a high risk of losing money rapidly. Leverage lets a small deposit control a much larger trade, so it also magnifies every gain and every loss. This disclosure lists every kind of risk the product carries in numbered sections, so that you can see all of them in one place. The main point is that most retail accounts lose money, and the figures behind that statement are the regulators’ own.

7 min readUpdated

Nothing on TheTraderWiki is investment advice, a recommendation or an invitation to trade. TheTraderWiki is a publication, and the site holds no client money.

Risk warning

Most retail accounts lose money trading CFDs

Most retail accounts lose money trading CFDs, and you can lose your whole deposit in minutes. In 2018 the European Securities and Markets Authority (ESMA) published what national regulators had measured: between 74 % and 89 % of retail accounts lost money. Average losses per client came in between €1,600 and €29,000 (ESMA press release, 27 March 2018). In a 2016 sample, the FCA found that 82 % of clients had lost money (FCA CP16/40). A provider regulated in the EU or the UK must publish its own percentage in a standard warning (ESMA Decision (EU) 2018/796, FCA PS19/18). A provider regulated elsewhere is subject to its own regulator’s rules on risk warnings.

The categories of risk

A CFD carries ten categories of risk, and they build on each other. A leveraged trade held overnight in a quiet market at a provider with little capital behind it exposes you to all ten at once.

1. Leverage risk

Leverage risk is the risk that a small price move in the underlying asset causes a large loss compared with your margin, the deposit the provider holds against the trade. The reason is that profit and loss are worked out on the full notional value of the trade, its total size. At 30:1, the highest retail leverage a provider regulated in the EU or the UK may give, a move of about 3.3 % against you wipes out the whole margin. A provider regulated elsewhere may allow higher leverage. A smaller move then has the same effect. At any leverage, the loss can be larger than the margin held for that one trade (ESMA Decision (EU) 2018/796, leverage and margin).

2. Loss of capital

Loss of capital is the risk that you lose the entire balance of your account. Negative balance protection is the rule that stops your account going below zero. If you are a retail client, the default category for individual traders, and you have negative balance protection, that balance is the most you can lose. Whether a provider gives it, including a group’s global company, depends on that provider’s regulator and the terms of its own contract. The balance is not the limit of your loss if you are a professional client, a category without the retail protections, or if your provider gives no such protection. The regulators’ loss statistics show that losing the whole balance is common (ESMA press release, 27 March 2018).

3. Gap risk

Gap risk is the risk that the price of the underlying asset jumps from one level to another with no trading in between. At a market open, over the weekend or on news, such gaps occur. A stop-loss is an order to close your trade automatically at a price you set. When a stop-loss price sits inside the gap, the order fills at the first available price on the far side and your loss is bigger than planned (risk management). No stop-loss removes gap risk.

4. Margin close-out risk

Margin close-out risk is the risk that the provider closes your trades at the market price without your consent, and often at the worst point of a move. Where the provider is regulated in the EU or the UK, the retail rules say when this must happen (ESMA Decision (EU) 2018/796, FCA PS19/18). That point is when your account’s equity falls to 50 % of the total margin needed for your open trades, and the provider must close out. A provider regulated elsewhere sets its close-out level under its own regulator’s rules and its contract. Equity means your balance plus or minus the profit or loss on the trades you have open. A close-out makes the loss final, and the trade can no longer recover.

5. Financing and cost risk

Financing and cost risk is the risk that charges use up the money in your account, whether or not the price moves. The charges include the spread, the gap between the buying and selling price, as well as commission, currency conversion and other fees. They also include overnight financing, a charge for keeping a trade open past the provider’s daily cut-off. Each of these is charged on a losing trade and on a winning one. Most are charged on the full notional value (costs and fees). Held for weeks, a trade can pay more in financing than it could reasonably earn.

6. Counterparty risk

Counterparty risk is the risk that the provider fails or does not pay. Every trade you make has the provider on the other side, and the provider holds every deposit. A provider regulated in the UK or the EU must keep your money separate from its own, so client-money segregation lessens this risk. At a provider regulated elsewhere, the protection rests on its own regulator and its client agreement. If a firm has no authorisation at all, nothing reduces the risk (choosing a provider).

7. Currency risk

Currency risk is the risk that a trade priced in another currency gains or loses on the exchange rate, on top of any move in the underlying asset. That applies when the trade’s currency differs from your account’s base currency, the currency your balance is held in. The provider also charges a conversion mark-up on the profit or loss, and sometimes on the margin (costs and fees).

8. Liquidity risk

Liquidity risk is the risk that you cannot close a trade at or near the quoted price because the market is thin. A thin market is one where few people are buying and selling. A market can be thin at the daily rollover. The daily rollover is the cut-off when overnight charges are applied. A market can also be thin overnight, at the weekend or when trading is disrupted. At those times spreads widen and slippage grows. Slippage is the difference between the price you expected and the price you actually get. The provider may also stop quoting an instrument altogether (forex trading).

9. Technology risk

Technology risk is the risk that the platform, your connection or the provider’s systems fail when you need to place an order or close a trade. Mistakes fall under technology risk too. You can enter an order wrongly. Automated trading does exactly what its code says, even when that is not what you intended. Holding a stop-loss on the provider’s server reduces this risk but does not remove it (trading platforms).

10. Regulatory and jurisdictional risk

Regulatory and jurisdictional risk is the risk that the protections you rely on do not apply. The protections can fail to apply when the company you have a contract with is authorised somewhere else or nowhere. These protections can also fail to apply if you have been classified as a professional client, or if the rules change. The protections you have come from the company named in your client agreement and its regulator, not from the wider group. The tax treatment of CFD results depends on jurisdiction and circumstances and is a matter for a qualified adviser.

No advice and no recommendation

TheTraderWiki gives no advice and makes no recommendation. The site explains how the product works, what it costs, what the rules are and how the arithmetic of risk behaves. The site does not tell you whether to trade, what to trade or how much. If you are unsure whether a leveraged product is appropriate for you, consult a qualified, independent adviser before you deposit money with any provider. Read the provider’s own risk warning too. A provider regulated in the EU or the UK gives its actual loss rate in that warning (ESMA Decision (EU) 2018/796, FCA PS19/18).

Information about providers

TheTraderWiki takes its information about providers from their published terms and from regulators’ public registers, and records the date each item was checked. No provider pays TheTraderWiki. Providers change their terms without telling anyone, so a detail may be out of date or wrong when you read it. Before you open an account or deposit money, check the current terms with the provider and its licence on the regulator’s own register. The decision to trade is yours.

Sources

The original documents this page cites, in the order they first appear.

  1. European Securities and Markets Authority, ESMA
  2. ESMA agrees to prohibit binary options and restrict CFDs to protect retail investors, ESMA, 2018-03-27
  3. Financial Conduct Authority, FCA
  4. CP16/40: Enhancing conduct of business rules for firms providing contract for difference products to retail clients, FCA, 2016-12-06
  5. ESMA Decision (EU) 2018/796 of 22 May 2018 to temporarily restrict contracts for differences in the Union, Official Journal of the European Union (EUR-Lex), 2018-05-22
  6. PS19/18: Restricting contract for difference products sold to retail clients, FCA, 2019-07-01