When you trade CFDs there are a few things you should know. The most important is that trading in CFDs can be high risk when you do not contribute the full value of the CFD being purchased and may not be suitable for every SMSF investor. However, trading CFDs is allowable by law, so ultimately it is up to you as the SMSF Trustee to decide whether or not you are comfortable trading CFDs for your SMSF. Prior to doing so however, it is advisable you seek independent professional advice and understand the following risks involved.
With CFDs, you deposit a small percentage (or margin) of the total value of the underlying asset in order to secure a trade. This means that if you buy $10,000 worth of BHP CFDs that have a margin requirement of 5%, you only need to provide margin of $500 to open the position. However, your exposure to the market (or risk) is the same as if you'd purchased $10,000 worth of shares at face value. Of course the Leverage Risk can be lowered by providing more of the purchase amount to finance the CFD.
You are not buying or trading the underlying asset
A CFD is a contract between you and the CFD Provider that could result in either a profit or a loss from either rising or falling prices. While the price of the CFD usually mimics the price of the underlying asset this isn't always the case. You need to be aware that you are not buying the underlying asset.
You can lose more than your initial deposit
When you trade CFDs you are required to provide a small percentage of your total exposure, in the form of margin payment. However, your total profit and loss potential is much greater than the amount of margin that you pay. So, if you buy $10,000 worth of BHP CFDs with a margin requirement of 5%, you only need to provide margin of $500 to open the position. If the position moves against you by 10%, you will lose $1,000, double your initial deposit. Depending on the CFD trades you've opened, and how long they are open for, the CFD Provider may require you to pay financing costs. You will incur these financing costs on a daily basis when you keep CFDs on certain underlying assets open overnight. In some cases, particularly if you hold CFDs for a long time, the aggregate of these financing costs may exceed the amount of any profits or significantly increase losses. If the position moves against you, or you allow financing costs to add up, you could lose more than you have deposited.
Risk of margin call and liquidation (or close-out)
To keep CFD positions open, you need to have enough funds in your account to cover your margin obligations. When your margin obligations are no longer covered, you must immediately deposit additional cleared funds or close positions so that the funds in your account cover the margin. Margin shortages can arise quickly as market values change and may arise outside normal business hours if you are trading international markets. Unless you have sufficient funds in your account to cover these situations, there is a risk of having to close positions when you may prefer not to.
Liquidation (or close-out)
The value of your account must always remain above the liquidation, or close out, level. If it falls below this level, your CFD trades are at risk of being liquidated. The CFD Provider may liquidate your position to protect both you and the CFD Provider, as no one wants your account to move into a debit position. It's up to you to monitor your positions. To prevent liquidation of your CFD positions, you must make sure you have deposited enough funds to keep your account value above the liquidation level. If your trade does not go as you expect, you may be required to deposit additional funds with the CFD Provider in order to hold your position.
A counterparty is the person or company on the other side of a financial transaction. When you take a CFD position, you are buying a contract issued by the CFD Provider, and as a result the CFD Provider is your counterparty in the transaction. There is a risk that, as the counterparty to the trade, the CFD Provider may fail to fulfil their obligations to you. This may be because the CFD Provider, or one of their own counterparties (such as a hedge provider), fall into financial difficulties.
Client Money Risk
Client money is held in a segregated trust account, separate from CMC Markets' own funds. Client money is deposited into this account either on the day it is received or owed to you, or on the next business day. As soon as that money is deposited into that account, it is protected. Client money is not used to meet the trading obligations of other clients. Client money on deposit with CMC Markets is held in a separate trust account established, maintained and operated in accordance with the Australian Client Money Rules. This means that client moneys are protected. When you place a trade with CMC Markets, CMC Markets are entitled to withdraw the initial margin and any other amounts payable. Money withdrawn by CMC Markets for these purposes ceases to be client money and will no longer be held in the segregated account. You are an unsecured creditor in respect of moneys owed, and you should be aware of this in the unlikely event that CMC Markets were to become insolvent. By way of example, assume you open an account with CMC Markets and deposit $10,000. If you decide to open a position which has a margin requirement of $1,000, your "Free Equity" would be $9,000. That $1,000 margin requirement (along with the other withdrawals and deductions such as commission charged to enter the position or financing charged to hold the position), are not protected in the same way as the remaining $9,000 in your account.
CFDs are Over the Counter (OTC) Derivatives
When you trade OTC CFDs, you are entering into an off-exchange (also known as an over-the-counter, or OTC) agreement with the CFD Provider. This means that CFDs are traded directly with the CFD Provider and not through an exchange such as the ASX. Therefore, you do not gain the benefits associated with trading through a licensed market (such as having a central clearing house guarantee obligations to you).
Financial markets may fluctuate rapidly, and prices offered by the CFD Provider reflect this. One risk that arises as a result of market volatility is gapping. Gapping occurs when there's a sudden shift in price from one level to another. There may not always be an opportunity for you to place an order between the two price levels, or for the platform to execute an open order at a price between those two levels. One of the flow-on effects of this may be that stop-loss orders are filled at unfavourable prices, either higher or lower than you may have anticipated.