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Why trading CFDs is a risky business for retail traders

Why trading CFDs is a risky business for retail traders

This article is in partnership with Safe Forex Brokers.

Online CFD trading in Australia is legal for retail traders and it is quite popular. Many CFD brokers have reported record trading volumes since the start of the pandemic due to the online trading boom.

But this growth for the industry comes at cost and risks for retail traders who are trading these leveraged instruments.

Several reports and data published by regulators state that as high as 60-85 per cent of retail CFD traders lose money and this begs the question, do retail CFD traders make money? And why is it so risky?

What is CFD trading?

CFD is short for Contract for difference. It is an over the counter (OTC) derivative product used for speculation and hedging in different assets.

A CFD contract is between two parties (usually a broker and a trader) where they agree to pay the difference by which the price of the underlying asset increases or decreases between the time the contract begins to the time the contract ends.

CFDs have no expiry date. Once a CFD contract is entered, an opposing trade will be required to end the contract.

CFDs can be used by retail traders to speculate on price changes of the underlying asset and also by investors to hedge against risk.

CFD trading allows traders to benefit from the rise or fall in underlying asset prices without actually taking delivery of the assets. These asset classes include but are not limited to currency, indices, commodities, stocks, and bonds.

For example, if you speculate that the price of a commodity like crude oil is going to increase, you can buy crude oil CFDs to profit from that rise.

On the other hand, if you speculate the price of crude oil will fall you can sell crude oil CFDs to profit from that fall. The same concept applies to other asset classes like forex, stock etc.

Popularity with retail traders

One of the reasons for the popularity of CFD trading is because of massive marketing by CFD brokers to gain clients. CFD brokers spend millions on marketing on social media, performance marketing, search and other marketing channels to gain new traders.

Most retail traders enter into CFD and forex trading in the hope of making a lot of money using leverage, even when they know from warnings by regulators that CFDs are complex products and most retail traders lose their money.

There have been some restrictions imposed by regulators on marketing by CFD brokers, like risk warnings, losses disclosure and the complex nature of the product, but this has not deterred new traders from opening CFD trading accounts.

Huge losses and subsequent growth during the COVID-19 pandemic

The pandemic caused many people to turn to retail online trading as an alternative means of income.

Perhaps, many people saw the stock markets going up and wanted to get in on the act and profit from the bull markets.

But just before the stock markets boom, the markets had crashed in March 2020, and retail CFD traders in Australia lost millions during the March-April period.

According to the Australia Securities and Investments Commission (ASIC) OTC derivatives trade repository data, there was an increase in CFD trading during the peak of the pandemic between January and April 2020.

ASIC also reported that the average transaction turnover by 12 major licensed Australian brokers grew from $1.6 billion before the pandemic to $3.3 billion during the peak period in the months of March and April 2020.

ASIC also reported that the number of new trading accounts opened per day with the 12 brokers surveyed grew from 1369 before the pandemic to 4675 during the peak of the pandemic. Also 142,022 dormant trading accounts were reactivated with the Australian brokers during the peak of the pandemic.

According to the ASIC report, retail CFD traders trading with 12 major CFD brokers in Australia lost over $428 Million gross in the week 16-12 March 2020.

5448 CFD traders' accounts even went into negative balance of over -$4 million aggregate. These losses exceed $774 million when five-week period of March and April 2020 was taken into consideration and over 1.1 million CFD positions were closed on margin call when balance of account fall below trading requirement and your position is closed in loss.

And 15,000 retail client accounts went to a negative balance of $10.9 million.

These losses were partly caused by wrong market timing, inexperience, overnight holding fees and also due to how CFD contracts are designed, like high overnight holding costs and availability of excessive leverage.

Many CFD brokers have gained 2-3X growth in 2020-21, even after the traders experienced huge losses during the market crash in March 2020.

For example, Exness (not regulated with ASIC) which is a popular CFD broker in Asia and Africa, recorded an increase in CFD trading volume as per the audited financial reports on their website.

The total monthly volume of CFDs traded with Exness grew from an average of about $400 billion before the pandemic in 2019, to $600 billion on average in 2020, and it has grown to $2.48 trillion in March 2022.

Australian forex and CFD brokers don't report their monthly data on trading volumes and active traders, but the stats at many CFD brokers that report their volumes indicate the huge growth for CFD brokers in the last two years.

Risky business

Trading CFDs carries certain risks which are not always apparent in the beginning as marketers of CFD products make them sound like easy to trade products. The more volatile the underlying asset is, the riskier CFD trading in the asset becomes.

This has made regulators around the world to step in and require CFD brokers to display a CFD risk statement on their websites.

According to Safe Forex Brokers Australia, major regulators like the FCA in the UK require regulated CFD brokers to disclose the exact percentage of money-losing CFD trading accounts on their UK website and on their marketing materials. The CFD brokers are required to update this information every month.

But this is currently not required for ASIC-regulated CFD brokers, so CFD brokers don't disclose this information on their Australian websites.

For example, Pepperstone, which is regulated with FCA in the UK and ASIC in Australia. On their UK website, they disclose "74.7 per cent of retail investor accounts lose money when trading spread bets and CFDs with this provider", but there is no similar discloser on their Australian website.

One major risk with CFD trading is the use of high leverage by retail traders to amplify their profits. But this actually results in increased losses.

Due to this, major regulators have put restrictions on the leverage CFD brokers can offer to retail traders. ASIC also issued product intervention order because of losses for retail traders in March 2020.

For example, in Australia, now leverage is restricted to 1:30 for forex, and lower for other CFD instruments with higher volatility.

By using leverage, traders risk losing a lot of money. Many retail traders can end up with a negative balance in their trading accounts.

ASIC found in their study that leverage restrictions could help reduce this exposure a lot.

They found that the aggregate net losses of clients dropped to $22 million from $372 million in the previous quarter prior to CFD restrictions.

There were now 45 per cent fewer loss-making accounts, retail position exposure size was also reduced by 86 per cent, margin close out also reduced by 85 per cent, client account entering negative balance has also reduced by ten times.

Clearly, leverage restrictions have helped reduce losses for many retail clients highlighting how having high leverage is risky.

Here's an example to highlight risk of using leverage in your trades: If your broker gives a leverage of 1:30 for forex trading it means that with $1 as your initial capital, you can trade $30 worth of the underlying asset. You will be required to deposit an amount called an initial margin into your trading account.

However don't be carried away because in as much as you could make more profit using leverage, you could also lose more than your initial capital if the market moves against you.

Let's take an example. You speculate that EUR/USD will rise from its present exchange rate of 1.10 and you want to profit from that rise so you quickly place an order to buy 100,000 units of CFDs.

Contract sum= 100,000 x 1.10= $110,000

Leverage = 1: 30

Initial margin= 3.33% of $110,000 = $3666

Outcome:

If the market moves against you by 5 per cent and EUR/USD falls to 1.05 you lose $5000, which is more than your initial capital or initial margin and you will still pay charges associated with trading, so your loss may be higher in the end.

If you had traded without leverage, you would have lost just 5 per cent of your initial capital. The more leverage you use, the faster your initial margin could turn to "used margin" and a "margin call" could be triggered which could lead to loss of funds.

Don't trade CFDs and forex if you are not a professional

CFDs are complex derivative instruments which involve the use of leverage. Such complex products should only be traded by professional traders who understand the risks and can afford the losses.

Given the fact that most of the retail traders lose their money, it is not a business that you should engage in. For retail CFD traders, there is a high chance that you will lose all your capital.

If you are trading with your money that you cannot afford to lose, then it can bring bad consequences.

Disclaimer: This information is of a general nature only and should not be regarded as specific to any particular situation. Readers are encouraged to seek appropriate professional advice based on their personal circumstances.