The Cyprus Securities and Exchange Commission (CySEC) published today on its official website what it calls an “Informative Article” about Contracts For Difference (CFDs).
Over just one paragraph explaining the concept of CFDs, the informative article warns about the risks of trading these instruments, also discouraging novice traders.
CFDs are leveraged products enabling investors to make transactions with only a small margin. However CySEC explains, although CFDs might look similar to more traditional investments, such as shares, in reality they are very different and far more complex. Due to their complicated structures and the high level of risk they carry, CFDs are considered by the financial supervisory authorities as being suitable only for professional clients or highly experienced retail investors who can understand how they work and the risks they entail.
Risks to Investors
CFDs are not standardized products and therefore each broker can apply different
terms and charges. The result of this according to the warning, is that costs for investors may be difficult to calculate for a given trade and may well outweigh the potential profit. The risk of investing in CFDs is especially increased when they are highly leveraged. Investors must remember that leverage can magnify the profits but it can also magnify the losses.
Furthermore, according to the commission, investment in CFDs also carries a liquidity risk. If an investor is unable to cover a loss, then the broker may liquidate all the CFD positions of the investor, even if the price of the underlying asset subsequently recovers resulting in a profit at a later stage. This is very important since it means that the investor stands to lose more money than his initial capital investment. Limits placed such as “stop loss” limits cannot always protect the investors from losses.
CySEC states that despite efforts by the supervisory authorities to contain such phenomena, companies offering trading in CFDs advertise the potential profits without adequately explaining or highlighting the risks to the investors. Also, various marketing ploys are used to lure investors in investing, such as “free start-up money”.
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In addition, CFDs are not suitable for investors who want to “buy and hold” their investments without monitoring their position on a regular basis, explains the regulator. The dynamic nature and volatility of the financial markets, together with the leverage, can expose the investor to great risk even by simply maintaining the investment overnight.
European Guidance on CFD Investor Protection
CySEC refers to the warnings to investors issued by the European Securities and Markets Authority (ESMA) as a source for the advice it offers traders thinking about investing in CFDs. According to these warnings, investors should choose to invest in CFDs only if they understand the product, have extensive experience in trading in CFDs and fully appreciate the risks involved. Also, before they decide to invest in CFDs, investors should ensure they have enough time to frequently monitor their investment.
Among other things, investors are advised to carefully read the contract they sign with the broker, making sure they fully understand the following:
– The costs of trading CFDs with the broker
– Whether the broker will disclose the margins it makes on the trades
– How the prices of the CFDs are determined by the broker
– What happens if the investor holds his position open overnight
– Whether the provider can change or re-quote the price once the investor places an order
– Whether the broker will execute the orders even if the underlying market is closed, and
whether there is an investor or deposit protection scheme in place in the event of
counterparty risk (if the broker defaults) or other client asset issues.
The informative article concludes the above list by reiterating that most importantly, investors are advised not to trade if they do not understand what is on offer.
Lastly, investors are reminded to check if the broker they intend to receive investment services from is authorized to provide investment services in their particular jurisdiction, and the warning refers readers to CySEC’s website to check whether a company is authorized to provide investment services in Cyprus.