CFDs are products that allow traders to make investments in an asset without actually owning it. They can be used to make speculative bets on global markets, and their rapid growth has been well-documented.
The growth of CFDs and other similar financial instruments such as spread betting has led commentators to question their suitability for retail investors who may not fully understand the risks involved. Yet despite this, many brokers see no reason why they should not continue to offer these products to their customers.
“It is easy money”, said one binary options broker when asked about the growth in popularity of CFD trading with retail clients. “They don’t know what they are doing, but they keep coming back to us anyway.”
While a lack of understanding may go some way toward explaining the meteoric growth in popularity of CFDs, it is only a component. High leverage and the opportunity for high returns on relatively small movements have led many traders to take up this form of trading, even with a good knowledge base. The attraction lies with the broker as it does with the product offering itself. Many brokers rely on inexperienced traders as they represent an ongoing revenue stream from those who will continue to trade regardless of their success rate.
In addition to offering high levels of leverage, there are also tax benefits associated with trading financial products, which are classed as CFDs by HMRC (Her Majesty’s Revenue & Customs. These are known as ‘Contracts for Difference’ or CFDs, defined as “rights under a contract relating to investments in securities, currencies, interest rates and commodities” and classified as “derivative instruments ‘.
Under this definition, HMRC does not tax profits made on the buying and selling derivatives until they are cashed in (‘realized’). It means that traders can make significant gains without paying any tax until the position is closed out. Although there will always be some debate about whether these products should be taxed in this way, it is an attractive prospect. Investors have no requirement to declare their activities on a tax return if they do not cash in the position.
While there is debate around whether CFDs should be available to retail clients, it would appear that the growth of this product will remain an attractive prospect for brokers regardless of its long-term viability. The opportunity to offer high levels of leverage and tax benefits makes them a good proposition for many brokers who rely on client turnover regardless of their success rate. It may well be the case that regulation will need to catch up with these products before they are phased out or become much more tightly controlled by financial authorities.
Until any changes are made, the risk associated with CFD trading remains. Given that most positions are not closed out, it can result in significant losses that far outweigh the amount paid as margin (deposit). It is especially the case with inexperienced traders who often fail to understand how quickly losses can mount up when trading CFDs.
If you want to mitigate these risks, consider limiting your CFD trading activity to those stocks with which you are familiar and only trade well-known blue chips. It will give you the best chance of success and allow for greater control over your emotions during periods of market volatility.
Most importantly, investors need to be aware that no matter how careful they are, there is always a possibility that you could lose more than you have put in, so never risk money that you cannot afford to lose.
There are still risks associated with CFD trading despite the growing popularity of this product. It’s because they are not regulated as strictly as other financial products, and brokers can continue offering them even when those who use them do so without understanding how they work.
Check out Saxo for assistance in mitigating your risks.