CFD leverage and margin
Leverage is a key feature of contract for difference (CFD) trading – enabling you to open positions by paying a fraction of their full value, known as your margin. Let’s take a look at how leverage works in CFDs.
- What is leverage in CFD trading
- How leverage works in CFDs
- Benefits of leverage
- CFD leverage example
- What is CFD margin
- Calculating margin
- The costs of leverage in CFDs
- How to manage CFD risks
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 stock broker, or you could buy 100 XYZ CFDs.
Either way, the total size of your position would be (25 * 100) $2500.
XYZ’s margin requirement is 30%. So by using CFDs, you only have to deposit $750 to execute your trade.
By trading on leverage, you’ve freed up additional funds to use elsewhere.
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 stock broker 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
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.
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. FOREX.com closes out positions after funds have dropped below 50% of the trade's margin requirement.
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
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%
- Close out your trade, realize the loss and reduce your overall margin requirement
- Partially close out your trades in order to reduce the size of your positions to free up some equity in your account
- 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
When you trade on leverage, your provider is essentially lending you the funds to cover the full size of your position. Overnight financing is the cost of keeping this loan open for more than a single trading day.
Three ways to manage CFD risks
1. Use margin sensibly
It’s usually a good idea to be prudent when sizing CFD positions, instead of using up all the free equity in your account as margin. As we’ve already covered, you could quickly find yourself close to a liquidation otherwise.
Many traders limit themselves to only risking 1% or 2% of their total funds on an individual opportunity. That way, you can sustain multiple losses without running the risk of a margin call.
2. Use stop orders
Stop orders will automatically close out a trade if it hits a certain level of loss – which can help limit your risk on any given position. You can add them via the deal ticket, or to an existing trade.
When placing a stop order, it is important to note that the price at which your position is closed could be different from where you placed your order, if the market gaps. Gaps can occur when there is significant market volatility and prices change rapidly, or when markets reopen after being closed (such as after the weekend) meaning that closing prices can differ from the trigger prices that have been set.
3. Use CFDs to hedge
As CFDs allow you to short sell and potentially profit from falling market prices, they are sometimes used as a hedging tool by investors as insurance to offset losses made in their portfolios.
For example, if you have a long-term portfolio, but feel that there is a short-term risk to the value of your investments, you could use CFDs to mitigate a short-term loss by hedging your position.
This way, if the value of your portfolio does fall, the profit in the CFDs would help you offset these losses, enabling you to retain your portfolio without incurring any significant loss to its overall value.