What is Leverage in CFD Trading?

In CFD trading, leverage is the ability to trade without paying for the full value of your position upfront. Instead, you only have to pay a deposit called your margin. While leverage is a powerful benefit, it will also increase your risk. So, before you start trading on margin, it’s a good idea to learn how it works – and how to manage risk using stop losses.

How Leverage Works in CFDs

Leverage works in CFDs because you never own the asset you’re buying and selling. You’re only speculating on price movements, which means you don’t have to pay for the full value of your chosen asset outright. Say, for example, that you want to trade 10 US 500 CFDs when the S&P 500 is at 4500. The full value of your position is (10 * 4500) $45,000, but you won’t need that much in your account to execute your trade. You’ll just need to put down your margin. Your profit or loss, though, will still be based on the full $45,000. You’ll make $10 for every point that the S&P moves up, and lose $10 for every point it moves down.

Benefits of Leverage

Trading on leverage means you can gain the same amount of market exposure by depositing just a small fraction of the total value of your trade. This can be useful to CFD traders because it means that they can put their money to use elsewhere. In our example above, you might only have to pay 5% of $45,000, or $2250, to open your position. That frees up the remaining $42,750. Another key benefit of leverage is that it helps magnify your returns, which is great news if the market moves in the direction that you expect. However, this comes with the downside that leverage will also magnify your losses – in exactly the same way as your gains. There is the potential to lose part and more of your investment if you do not manage your risk efficiently. Remember, with leveraged trading your capital is at risk.

CFD Leverage Example: Stock Trading vs CFDs

To see how leveraged CFDs work in practice, let’s take a look at an example. You want to trade 1000 shares in company XYZ, which has a current stock price of $25. You could invest in XYZ using a stockbroker, or you could buy 100 XYZ CFDs. Either way, the total size of your position would be (25 * 100) $2500.

 

How Leverage Can Magnify Profits

Company XYZ’s stock price rallies after strong earnings, increasing to $26 – so you decide to close out your trade. With both a traditional stockbroker and CFD trading, you would have made a return of (26-25 * 1000) $100. However, the return on your CFD would be 13.3%, compared to just 4% on your investment. Why? Because you only deposited $750 to open the CFD position.

How Leverage Can Magnify Losses

That’s how leverage works with a profitable position – but the same will apply if you close out at a loss. Suppose your trade on XYZ was unsuccessful and you decide to close with a $100 loss. In this scenario, the return on your CFD deposit would be -13.3%, because you’ve lost $100 when you deposited $750. The return on your stock trade, meanwhile, would be -4%. Using leverage has magnified your losses.

What is CFD Margin?

CFD margin is the deposit that you’ll need to have in your account to trade a contract for difference. You’ll also see it referred to as a market’s margin factor or margin requirement. Margin factors vary across markets, and are usually given as a percentage. The percentage tells you how much of your position’s full value you’ll need to deposit. Generally speaking, the higher the requirement, the more volatile or illiquid the market.

Margin Calls and Close Out Levels

To keep a leveraged trade open, you’ll need to ensure that you have the required funds in your account to cover your margin at all times – especially if your position is at a loss. Say, for instance, that you’ve only deposited the required $750 to buy your XYZ CFDs. If XYZ’s stock price drops and your position sits at -$50, then you’ll only have $700 equity in your account, which isn’t enough to cover your margin requirement. This situation is called a margin call, and means your position is at risk of being closed or liquidated. Frontbroker closes out positions after funds have dropped below 100% of the trade’s margin requirement. To avoid liquidation, you should always ensure you have sufficient funds in your account to cover your maximum loss for the period that you decide to hold open your trade.

How Do I Calculate My Required Margin?

To calculate your required margin on any position, you need to know its total size and margin requirement. If, for example, you want to buy 5 UK 100 CFDs at 6800 and the UK 100 has a margin factor of 15%:

• The total size of your position is (5 * 6800) £34,000
• 15% of 34,000 is £5,100
• You need £5,100, converted into your base currency, in your account as margin in your account as margin

However, you don’t need to calculate any of this manually – whenever you open a position on the Frontbroker platform, you’ll see how much you’ll need in your account displayed in the deal ticket.

Keeping Positions Open

When you have multiple positions open at once, keeping track of your total margin requirement can be tricky. But again, you don’t need to calculate anything yourself. Instead, you can use the Margin Indicator on the FOREX.com platform. The Margin Indicator is always displayed at the top of the FOREX.com platform, or in the dropdown from the top of the mobile app. It tells you how much equity you have in your account, compared to your total margin requirement.

• If the indicator is greater than 200%, then you have the funds required to keep your positions open
• If it falls below 200%, you are at risk of your trade falling further and automatically being closed out
• Should it fall below 100%, you no longer have enough funds in your account to cover your total margin. A warning symbol will be displayed next to the indicator if it drops below 120%

What should you do if you are close to a liquidation? If you are getting close to a liquidation, you have three potential options:

1. Close out your trade, realize the loss and reduce your overall margin requirement
2. Partially close out your trades in order to reduce the size of your positions to free up some equity in your account
3. Add additional funds to your account. You’ll need to cover the shortfall in margin, and may want to consider additional funds to sustain any further losses

Managing CFD Risks

• Use margin sensibly
• Use stop orders
• Use CFDs to hedge

The Costs of Leveraged Trading

As well as margin, there are other costs you’ll have to pay to cover a leveraged CFD trade. Chief of these is overnight financing.