Complex Instruments Risk

Contract for Difference

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Complex financial instruments are high risk. If you invest in these, you need to be aware that you could lose all your money.

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CFDs (Contract for Difference) is a complex financial instrument, that allows a trader to buy or sell the underlying asset, e.g., a stock, without taking ownership of it. It allows you to trade the price movements of that asset.

 

For example:

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When you invest in stocks in a company, you own a piece of that company. Therefore, you have a stake in its financial fortunes. When its value increases, so does the value of the stocks you own. When the company’s value decreases, the stocks you own lose value.

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When you trade stocks using CFDs, you don’t own a piece of that company. You don’t have a direct stake in the company’s fortunes. Instead, you have a contract that derives its value. The contract stipulates that the buyer must pay the difference between the current value of the stock and the value at the time it was executed.

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So, if you traded a stock CFD, when the price was £10 and, when you came to sell, the stock CFD priced at £20, you’d receive the difference between the two figures. So, in this case, you’d make £10 profit.

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Because you’re trading on price movements instead of buying the underlying asset, you can take either side of the coin. You take a long position if you think the price of the underlying asset will increase, or you can take a short position if you believe the asset’s value will decrease.

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CFD trading gives you the option to buy or sell positions. However, this ability to take either position can present some problems, particularly if you’re a novice. Therefore, before you start CFD trading you need to consider the risks.  

 

Leverage

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Using leverage in trading means you’re taking a position with a small amount of your own money and funds “borrowed” from a broker. The difference between the amount of money you commit to a trade and the amount of money you borrow is known as the margin. So, when you leverage up your money using borrowed funds, you’re trading on margin. CFD trading allows you to take higher leverage than other financial instruments.

 

For example:

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It could be possible to get leverage of 1:30. This means that the broker will put in 30 units for every one unit you commit. Trading with leverage means you can take a bigger position for a smaller outlay. With a bigger position, you can make more profit. The counter to this is that you can lose more money when you trade on leverage.

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This is where the losses you experience are multiplied due to leverage. If your losses mount up sufficiently, your position could be closed due to a lack of funds. A major risk is exponential losses.

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Using the above example, where you made £10 profit. Using leverage of 1:30, your profits would be £300. If the price, however went from £10 to £5, on 1:30 you would lose £150.00. 

 

There are Costs Involved

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CFD trading isn’t free. Brokers use something known as the spread to cover their costs. The spread is the difference between the buy and sell price. This small cost must be factored in. For example, CFD trading strategies that require you to move into and out of positions multiple times per day (i.e., day trading) can be costly because you have to cover the spread each time you buy and sell.

 

CFD Trading Rules Can Vary

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You need to think about regulation. The rules for trading CFDs can vary from country to country. Therefore, make sure you know how to trade CFDs in your location and know what country your broker is regulated in.

Leverage, Margin and Liquidation Risks

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Using leverage can lead to exponential losses when a trade doesn’t go your way. Trading with leverage (on margin) can cause you to lose money faster than usual. This can lead to your position being liquidated due to a lack of funds.

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On average between 68% - 83% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

 

Securitised Derivatives

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Securitised derivatives are issued by a financial institution and give you the right to acquire or sell one or more types of investment or to speculate on the value of an index during a specific time period. A relatively small movement in the value of an underlying investment or index will result in a much larger movement in the price of the securitised derivative. The price of these investments is therefore volatile. You should not buy a securitised derivative unless you are prepared to lose all the money you have invested. Examples of these types of security are Exchange Traded Notes (ETNs) and Exchange Traded Commodities (ETCs).

 

Structured Products

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A structured product – also known as a structured capital-at-risk product – is an investment which offers a pre-packaged investment strategy based on derivatives and which delivers a known return for given conditions. It may be based on a single investment, a basket of investments, options, indices, commodities, debt issuances, foreign currencies or swaps or any combination of these. Their reliance on derivatives means that structured products are high risk investments, and you could lose all the money you have invested.

 

Short, Leveraged or Synthetic Exchange Traded Products

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Unlike physical replication, a synthetic ETP does not hold the underlying assets the product is designed to track. Instead, the ETP issuer enters into a swap agreement with a counterparty that contracts to provide the return based on the performance of the underlying assets.

 

Leveraged ETPs use complex financial techniques to increase the potential return of their investment. Short ETPs aim to deliver inverse performance to an underlying index or asset class using derivatives and short selling techniques. Leveraged ETPs amplify gains and losses relative to the underlying index or asset class.

 

Specialist Collective Investments

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A collective investment may be highly specialised and include investment in hedge funds, private equity, infrastructure, property, or other illiquid asset classes.  It may have a sophisticated structure and/or complex performance related charging and may have exposure to specialist geographical areas or other security types.

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To learn more about high-risk investments, and five important questions to ask yourself before you consider investing in them click here.

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