Submitted by: A Jessen
Whilst Index CFDs are an exciting product they do come with some built in risks that we’ll have a look at today. One of the most important elements when you start out as a trader in any market is to minimise your losses and to minimise your risks. So whilst index CFDs do provide amazing opportunity you also have to recognise that there are inherent risks built into this product.
1% margin means very high levels of potential leverage
By far the greatest attraction of Contracts for Difference or CFDs to the retail trader is access to vast amounts of leverage. Marketing brochures indicating 1-10% margin are on every trading magazine and offer traders the belief of staggering returns. Index CFDs usually only require 1% margin up from, so $1,000 will control $100,000 worth of Index CFDs.
The potential leverage you have at your finger tips is amazing but also poses your greatest risk when trading index CFDs. The reason for this is a small percentage move in your favor means a great return on your outlay but a small percentage move against could wipe out your account. The rule of thumb with index CFDs is to trade cautiously until you build up your trading confidence. Start small and use little if any leverage to begin with and keep those losses as small as can be.
Be careful of the spread – Futures versus Index CFDs
Most Market Makers offering Index CFDs have a 2 point spread but allow you to trade commission free and as little as 1 contract at a time or $1 per point. Buying and selling at $1 per point usually doesn’t register in the minds of traders as expensive but let’s run a comparison against the real Aussie SPI 200 Futures contract for example.
The SPI futures contract has a minimum of $25 per point for 1 contract. To get the same exposure with Index CFDs would require 25 contracts. Now think for a second about your commission due to the spread. Futures might charge $5 per contract online commission whereas your Index CFD broker will charge you the spread or the full 2 points.
Even though its commission free you are paying the spread. This means if you got in and you wanted to get out straight away you would lose 2 points times the number of contracts or in this case 2 times $25 or $50 per side. So in the futures market you pay around $5 per full contracts and with the so called commission free trading you pay around $50 per 25 lot.
Greed, Leverage and Volatility
Lastly the real killer is your own greed coupled with leverage and the normal market volatility. If you start pushing your account due to greed and begin trading at high levels of leverage you are putting yourself right in the firing line for a disastrous situation. 1% margin tends to attract those with the wrong mindset chasing trading systems that have never been proven and is the fastest road to the poor house. Index CFDs need to be traded with low levels of leverage with your greed left at the front door every time.
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