
Liquidity Risks and Gapping
Market conditions affect many financial transactions and may increase the risk of losses. When there are not enough trades being made in the market for an underlying asset, your existing contract can become illiquid.
At this point a CFD provider can require additional margin payments or close contracts at inferior prices. Due to the fast moving nature of financial markets, the price of a CFD can fall before your trade can be executed at a previously agreed upon price, also known as gapping.
This means the holder of an existing contract would be required to take less than optimal profits or cover any losses incurred by the CFD provider.
The counterparty is the company which provides the asset in a financial transaction. When buying or selling a CFD, the only asset being traded is the contract issued by the CFD provider. This exposes the trader to the provider’s other counterparties, including other clients the CFD provider conducts business with. The risk associated with counterparties is one which the counterparty fails to fulfill their financial obligations. If the provider is unable to meet these obligations then the value of the underlying asset is no longer relevant.
Conversely, an investor will choose a short position if they believe the value of the asset will fall. You hope that the value of the underlying asset will move in the direction most favorable to you. In reality, even the most educated investors can be proven wrong. Unexpected information, changes in market conditions and government policy can result in quick changes.
Due to the nature of CFDs, small changes may have a big impact on returns. An unfavorable effect on the value of the underlying asset may cause the provider to demand a second margin payment. If margin calls can’t be met, the provider may close your position or you may have to sell at a loss.
When a contract is agreed upon, the provider withdraws an initial margin and has the right to request further margins from the pooled account. If the other clients in the pooled account fail to meet margin calls, the CFD provider has the right to draft from the pooled account with potential to affect potential returns.