The use of leverage is considered to be a trader’s best friend, sadly the recent week’s activities led the Japanese Financial Services Agency to announce a public consultation on plans to take control and limit leverage on contracts for difference (CFDs). A suggested limit of five times for shares, ten times for equity and 50 times for bonds will be consulted based on the growing concerns that traders are leveraging too much to gain more profit.
CFDs on precious metals and commodities are reportedly not subjected to any limits. Although the UK Financial Services Authority still in mum regarding its opinion, hopefully the potential restrictions about the leverage conditions will surface in the near future.
One of the many things that make CFDs very appealing to traders is the rewards and relative risk involve that comes along with it. How then should traders make use of leverage and how can they ensure enough exposure to the market to expand and grow without going beyond the limits of their investment? The leverage permissible is a function of the margin actually required which is the amount of money that is present in a trader’s account in order to open a CFD position of a particular size in a chosen asset.
Such that the leverage is the position size divided by the margin required therefore it would be multiplied depending on the trader’s digression. Under the Japanese proposal, the leverage would have to be maximised five times for example; a trader would need a £200 in their account in order for them to take out the CFD in the stock. However, it still would be the providers call to set their own marginal requirement and the leverage required for each principal asset.
Ideally, the margin will be largely based on the instrument’s volatility, the liquidity of the principal market and the cost of the provider heads in the hedging standpoint. Normally this would mean that the fluidity of the market such as currency pairings and large cap corporations will have the lowest margin requirements as well as the highest leverage. The less liquid and more volatile assets namely small caps will have the highest margin requirements. Although this is certainly not the case and CFD traders must be aware of the needed obligations of their position since it can change very quickly.
This should greatly assist traders manage their exposure by making sure that they won’t end up being overly exposed at risk of losing too much. While leverage can be a comforting ally by letting traders gain more exposure to an underlying asset it can also expand losses greatly should things go drastic and out of the way.
Fortunately, there are other means aside from stop losses that can help traders significantly reduce the risk. One of which is the use of trading low margins with trade pairs – going short on one company and longer in another. Famous pair trades include AstraZenaca and CFD Profile Sterling US Dollar Spread. Although both the Sterling and US dollar are currently weak, any corrective bounce of the pair remains very much vulnerable to disappointing US figures.