The trading of Contracts For Difference can be an extremely beneficial form of investing for many people due to the ability to leverage, the flexibility they brings and tax savings. There are, however some disadvantages that should be assessed when deciding on whether it is the right form of investing for you. We will look at the various disadvantages and discuss them in more detail.
Perhaps the biggest problem with CFD trading is conversely one of the main reasons people trade CFDs in the first place – leverage. Leverage or margin trading is a feature of CFDs that means you are only required to open a contract with small percentage of its value. This percentage varies depending on the provider but if we use an example of 20%, if you wanted to trade a Rio Tinto contract worth £100,000, you would only need £20,000 to do so.
The problem with leverage is that is brings about a high level of risk that can catch anyone out. When markets rise, it is an excellent feature and can bring about huge profits in next to no time. When though markets get hit and prices recede, it is possible to find yourself with a very sick feeling in your stomach just as fast.
To protect yourself from dramatic losses it is highly recommended that you make use of a stop loss with any contract you open. When you set a stop loss you are basically deciding on a price where the contract will automatically closed if that price is triggered. For example if the HSBC share price was 546 pence and you didn’t want to hold a contract is the share price went below 520 pence, you could set a stop loss up to protect you from this. A stop loss is an excellent tool that when managed properly can help any investor save money when trading CFDs and is extremely easy to use, no matter how experienced you are.
The second disadvantage to consider is the cost of holding long term positions. CFD trading requires a contract holder to pay an overnight financing fee on the leveraged portion of the contract. This is because you are essentially borrowing money from the provider to hold the position and need to cover the cost to the company. This fee tends to be calculated at the Reserve Bank’s interbank overnight cash rate plus/minus 2 to 3 per cent.
Another disadvantage of CFD trading is that you miss out on the many of the rights that come with physically holding an asset such as a share certificate. If you physically hold a share you are entitled to voting rights on important decisions the company faces. If you trade CFDs though you are trading a derivative so don’t have any say in how the company is run. This won’t matter to the majority of people everyone but if you like to be a bit more hands on then you should this. Please note that although you do not own the shares, you are still entitles to dividends if they are issued.
When deciding upon whether CFD trading is for you, it is certainly worth considering what we have discussed and weighing it up against other forms of investment that you are considering. If you would like to try trading Contracts For Difference in a risk free environment to see if it is for you, most providers offer a demo account that you can use to learn the ropes. Good luck and happy trading!