Trading on Margin
Part of the extensive attraction of CFD trading is the fact that CFDs are traded on margin. Margin trading with CFDs is what allows leverage to account for a proportion of each trade, and understanding how and why it works is key to developing a holistic knowledge of successful CFD trading. The margin component of CFD transactions is what sets the degree of leverage applicable to a given trade, and usually this is fixed depending on the market or instrument up for consideration, and expressed as a percentage of equity each trade requires upfront from the trader.
Consider the following example, for a more rounded explanation of how the concept of margin works in terms of the formulation of the transaction. Say the FTSE 100 is tradable with a notional margin requirement of 5%, and you wish to take exposure to the FTSE through CFDs, up to a value of £100 of your capital. This margin requirement means that your capital can effectively go 20 times further with CFDs than with a direct investment, because 95% of the transaction is composed of borrowed funding. So, your £100 in capital becomes 5% of your total available transaction size, which means the total transaction size you can muster becomes £2,000. When the market moves up 10 percentage points, this delivers a £2,200 return, which leaves £200 in gross profit after the leveraged amount is repaid. Thus, the margined nature of the transaction both increases the sizes of the available investment pot, while also ensuring a better rate of return can be realised.
This requirement for margin is notional. There is no need to negotiate financing terms or to consider fluctuating rates of interest – the terms are generally set in concrete and funding automatically approved, so long as the condition of meeting the 5% margin requirement continues to be met. If the position loses value, the margin requirement will adjust to ensure that the trader is always exposed to 5% of the total transaction size at any one time. If the situation arises whereby that 5% is unable to be met by liquid capital, the broker will automatically close out other positions in order to offset against their losses – what’s known in the business as a ‘margin call’. The margin call could see you losing your existing positions at best, or left with a hefty (and entirely legally enforceable) bill at the end of the day.
In worst-case scenarios, you may lose your assets if you run up large enough debts, and you should be consistently aware of the dangers posed by allowing margin-traded transactions to get out of hand. Every additional pound you lose is a pound you have to make up elsewhere, and just because your broker is on the other side of your PC screen makes no difference to the enforceability of your obligations.
While margin trading on CFDs enables traders to engage in positions much more significant than their capital resources would allow, it also presents real and present risks in practice, as a direct result of the degree of leverage built in to these transactions. While the benefits of amplified gains are clear to see, any trader speculating on margin needs to remain fully cognisant of the correlative risks that run alongside greater, leveraged rewards.
Having looked at what margin trading means, and how it translates in practice, that now leads us to look at leverage in a bit more depth, including the advantages and disadvantages it presents traders, along with an analysis of how best the risks of leverage can be mitigated to minimise losses. By examining the function of leverage, and how it intersects with margin and the various different elements of the CFD trading puzzle, you can start to flesh out more concrete ideas about how to make leverage and margin trading work for you and your investment portfolio.