Contracts for Differences (CFDs) are popular trading vehicles that allow traders to speculate on the price movements of a wide range of financial markets without purchasing the underlying asset or instrument. They are a type of financial derivative, bought and sold in contracts.
CFD trading is popular with traders for many reasons – one of the main ones being the freedom from not being tied to the physical buying and selling of instruments, and the other being the use of leverage which can allow for the potential for large profits. Nevertheless, leverage goes both ways – and traders can incur great losses should the markets move against them. Therefore, CFD trading is classed as a high-risk activity that traders should be wary of.
In this article, we will look at how CFD trading works – particularly in the MENA region, and how traders can prepare and protect their portfolios from suffering unnecessary losses.
Understanding how CFDs work
CFD trading requires traders to open positions by speculating on the price movement of an asset. A trader who believes an instrument will increase in price will go ‘long’ which stipulates they will buy – entering into a contract with a CFD provider who acts as the counterparty.
If they believe the opposite will happen and an instrument will decrease in price, they will go ‘short’ which stipulates they will sell. When the markets do move, the profit or loss is calculated based on the difference between the entry price and the exit price, multiplied by the size of the position.
To increase potential profitability, traders typically use leverage. Leverage allows traders to increase the size of their position – a sort of magnifying effect – without increasing the money they put in at the outset.
Leverage is expressed in the form of a ratio, usually ranging from 1:2 to 1:30, depending on the asset that is being speculated on and the CFD provider that offers the contract. Riskier instruments such as cryptocurrencies will typically have lower leverage offered, while those that are relatively stable such as blue-chip stocks or instruments with small price movements like major forex pairs may have higher leverage offered.
CFD trading is popular because of the availability of leverage. Should the markets move favourably, traders can amplify their profits substantially. However, should they fluctuate or move against predictions, losses are similarly amplified – sometimes even exceeding the funds in a trader’s account.
The MENA CFD Regulatory Environment
The regulatory environment varies across the MENA region as it is made up of different countries with different financial regulatory bodies. It is always best to check what the national regulations are depending on where you are trading.
For instance, the UAE’s federal regulatory body is the SCA (Securities and Commodities Authority). Therefore, those that participate in CFD trading in Dubai will need to make sure they are working with a broker that is regulated and authorised by the SCA to ensure their funds are secure and they are trading safely. On the other hand, those trading in Saudi Arabia will need to ensure they are working with a broker that is regulated by the Capital Market Authority (CMA).
Risk Management Strategies for CFD Trading
Due to the high level of risk that CFD trading entails, it is essential that traders protect themselves and their portfolios adequately. This includes ensuring that they understand how CFD trading works – as well as other ways to minimise any potential losses.
Portfolio diversification
Anyone who has had experience in trading or investing will understand the unparalleled importance of portfolio diversification. CFD traders should avoid concentrating their entire portfolio in one single CFD position or asset class. Ideally, investments should be spread across different financial markets that are not correlated (not affected by each other).
Position sizing
Position sizing is the process of determining how large of a position a trader opens or takes on when they enter the market, based on their account size and risk tolerance. Typically, brokers have position sizing calculators that can help traders figure out the appropriate amount of risk to take on depending on their preferences, the instrument on which they would like to speculate, and other requirements. When only a small percentage of a trader’s total percentage is used, they reduce the risk they take on.
Calculated use of leverage
Leverage is powerful tool that can either enhance returns or cause traders to suffer catastrophic losses. Traders should ensure they manage their leverage utilisation appropriately and never trade with more than they can afford to lose.
Stop-loss orders
Finally, implementing stop-loss orders to automatically close out positions in case the market moves against predictions is always a good idea. Traders can set their preferred exit triggers before they enter the market, so that they do not have to constantly monitor the markets or risk missing their exit window.
Final words
CFD trading provides plenty of benefits and can be a good way for traders to participate in fast-moving markets. However, it is a high-risk activity that requires careful planning and execution, and those who wish to participate in trading them should understand how they work and only purchase contracts from providers and brokers that are regulated in their country or region.
They should also take note of – and apply – the appropriate risk management strategies depending on their risk profile and preferences in trading. Small profits can always be built up incrementally, but huge losses are difficult to recover from and pay off, and traders who do not take CFD trading risk management seriously will suffer substantial financial consequences.
