Trading CFDs 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.

Advantages Of Leverage

The advantages of leverage make perhaps the most compelling case of all for investing in CFDs as an alternative to straight, pound for pound investments. Afforded by the advent of margin trading, leverage has the power to inflate transaction sizes to artificially high levels, allowing for much larger gains to be made on comparatively smaller investments, meaning deployed capital can work much more efficiently than would otherwise be the case, and can deliver returns much more swiftly than most investors would otherwise expect.

Leverage works by establishing a casual borrowing relationship with the broker. Generally, this is offered to traders along with their CFD trading account, and there is no need to apply for leverage or ask your broker to do anything out of the ordinary. Put simply, leverage is automatic, notional funding that is applied by the broker to ‘make up’ to the total transaction size. In many cases, this is done in a ratio of around 1:20, with traders required to fund $1 of every $20 of the total transaction size.

This is equivalent to a margin requirement of 5%. So, for every trade you enter, you stump up 5% of the transaction in the first instance (which is deducted from your available capital), and then (crucially) keep the earnings on 100% of the transaction. When the market moves positively behind your position, you can close out, automatically repaying the amount of leverage footed by the broker in order to absorb the profits from your transaction.

Consider the following practical example. You see a CFD in Company X that catches your eye. With strong reason to believe that Company X will increase in its value over the duration of your investment, you decide to buy CFDs at $1 each to maximise your chances of a return. With $100 capital on the line, you buy $2000 worth of CFDs – bought with the 5% capital deposit of $100 plus the 95% leverage of $1900. When the value of Company X CFDs rises to $1.50, you decide to settle your position and sell up to take your profit.

The profit calculation becomes ($1.50 x 2000) – ($1 x 2000) + $100. Therefore, the profit portion from the trade is worth $3000-$2000+$100=$1,100. On a $100 initial investment, this represents an enormous return on investment that is simply unmatched with alternative means of trading the markets. Of course, this is a simplistic analysis of the figures, and in real life trading scenarios tend to be much more complicated and far less smooth. But it does go some way towards giving an indication of the most significant advantage of leverage.

Note that the leverage portion is silent in the transaction, and is borrowed and repaid without any input from the trader. The only point at which you will be required to act as a result of your leveraged dealings is in the event that the margin amount falls below 5% of the total transaction size, at which point any other liquid capital will be applied to your account, or any profitable positions liquidated to account for your liability. Of course, if the transaction loses value, you still have to repay the leverage amount – even where this extends beyond the amount you have remaining in the trade or in your account.

But aside from being purely a mechanism for boosting profits, leverage can also be a great help in reducing the aggregate losses from your trading portfolio. Imagine you’re sitting with a portfolio with 8 share positions and 2 CFD positions. If you’re down on your share positions, you better believe a profitable CFD position will help eat in to your liabilities. Remember that trading is a game of aggregates, and when aggregating a profit is what you’re after, CFD positions that work to efficiently return capital can be vital to composing a solid and profitable portfolio. Thus, leverage can be greatly advantageous, both as a profit-getter and a loss off-setter, combining the key characteristics of fast and efficient capital return to provide you with a range of trading benefits.

With the same breath, it’s critical to remember that leverage isn’t just a golden chalice from which you can make your fortune, but also a weapon that is potentially fatal to your trading career. In fact, for most traders, the disadvantages of leverage should be read first as a necessary dampener to the excitement that margin trading can instil, to ensure you don’t take unnecessary risks in the process of your CFD trading.

Disadvantages Of Leverage

The advantages of leverage are enough to make even the most experienced trader’s mouth water. The appeal of massive gains from seemingly minimal capital exposure, and the sheer volatility with which positions transpire in CFDs makes it an exciting world in which to do business. Trouble is, real life isn’t always as smooth as it may appear in theory. In fact, there have been growing calls amongst regulators internationally looking to clamp down on the less savvy consumer investment end of the market, with a view to curbing the rise in ‘mum and dad’ traders investing their life savings without a thorough understanding of the ins and outs of this complex and potentially highly risky investment strategy.

Whether you’re a high flying professional trader with years of experience or you’re a complete novice looking to make a quick return on your money, being conscious of the degree of severity of the risks posed by leverage is key to developing a robust risk management approach, and as a result is absolutely fundamental to your success when playing the markets.

The first and arguably most significant disadvantage with leverage is the inverse of its main advantage. When things are going well and the markets are going your way, leverage is a fantastic tool to have on your side, propping up your earnings and increasing the speed of your returns. For maximising your gains from each trade, there isn’t really anything better than massive leverage giving you the benefit of greater buying power. However, when markets and positions start to move against you, things can become pretty difficult pretty quickly with leverage turning against you to cause potentially extensive damage to your trading portfolio.

As leverage moves strongly in your favour, it also moves in equal strength against you when you call a position incorrectly, and both earnings and losses are as equally unlimited. Consider the following example.

Buying CFDs on corn, you assume the market will rise over the course of the day following an upcoming announcement anticipated to show weaker production than last year. For a $50 investment, you take $1000 worth of leveraged exposure to corn, in the hope that prices will rise on the day. But when the figures are released, production has flat lined on the year, surpassing what many had anticipated as being a weak crop. This has a knock-on effect on pricing because supply has remained constant rather than fallen, leading to the widespread selling of corn with speculators looking to cut their potential losses. As an aside, this is the point where you should seriously be looking at offloading your exposure as quickly as possible in order to take a small loss – a small premature loss is far better than a massive loss on a position when it is fully realised.

With corn prices falling by 10% on the day, your position has gone from being worth $1000 to now being worth $900. While this represents a 10% drop on the transaction’s value, it will have devastating implications for the trader.

The $1000 leverage amount still has to be repaid in full to the broker when the position is settled, including any outstanding financing costs. But the position now yields a $100 loss – that’s 200% down on the initial investment of $50. When multiplied over a number of positions across your portfolio, the speed and ruthlessness of leverage in chopping down the value of your positions is what makes it such a dangerous beast.

Aside from the risks posed by leverage in terms of amplifying losses to a greater extent, highly leveraged CFDs are also disadvantages with the passing of time, as a result of the way leverage is charged to traders. Holding a leveraged position overnight attracts a financing cost on the total size of the transaction, expressed as a percentage, and this is payable on every single position held overnight on a daily basis. While the percentages might not seem substantial, they are much more significant when calculated as a percentage of the initial capital deposit.

For example, assume the daily financing charge for a leveraged position is 0.03%. 0.03% on a position worth $1000 is equal to $0.30 per day. However, when that $1000 is actually composed of just $50 in capital, $0.30 becomes 0.6% of your capital exposure, applied as a daily expense. Hold the position for a week, and you’ve paid 4.2% – that’s a 4.2% higher hurdle to overcome towards making a profit. While this is by no means impossible, the higher trading costs associated with funding leveraged positions make calculating the risks and thinking through your trading strategies a must if you’re looking to trade profitably. When coupled with the increased risk profile of trading on margin, this adds up to make leverage a concept that can’t be taken likely.

2022-01-10T23:14:01+00:00

Leverage is one of the most considerable factors in the spread betting concept, and a core part of what makes it a popular trading method (in addition to spread betting favourable tax treatment). Without leverage, which represents the core of spread betting as a trading instrument, the opportunities for profiting from incremental ticks in the market would be significantly less frequent, and the spread betting proposition altogether less attractive.

Leverage, also known as gearing, is best described as an artificial amplification of a trading transaction size in order to deliver stronger returns on a given spread bet. In share dealing, for example, you may be able to arrange to cover 5% of a transaction’s total size with your own capital, with the remainder being funded by the broker on a short-term casual financing arrangement, thus allowing you to profit from market movements on the total transaction size rather than on a straight transaction for the same amount.

Leverage: Working Example

Let’s assume you have trading capital of £5. With leverage, you can notionally increase your trading capital to £100 for a particular transaction. When the market moves up 10%, your account will rise to £110, at which point the leverage portion is paid back to the broker. This leaves you with £110 – £95 – £5 = £10 in profit – a 200% return on your £5 capital. As this example expresses, leverage can be a significant earner, and helps make the most of winning positions when they arise.

How Leverage Works

The leverage component of spread betting works in a slightly different way, and can take place on two separate levels. Firstly, leverage is built into the spread betting transaction in the sense that minor movements are automatically geared up to deliver larger returns. Unlike most forms of leverage, which comes as a result of borrowed finance (and attract an additional cost as a result), the inherent leverage in spread betting arises by virtue of the fact that a one point movement returns 100% of the original wager. Of course, the same is also true in reverse, with a one point decline leading to a 100% loss, and so on. It is this leveraging effect that makes spread betting instantaneously both highly profitable and highly risky for investors.

The second element of leverage in spread betting transactions that can come into play is leverage in the more traditional sense – that’s leverage that is fronted by the broker and then paid for by the trader in the form of overnight financing costs. The impact of this kind of leverage is to artificially bolster the transaction size – so, instead of trading at 10p a point, you might be able to trade at £10 a point. This form of leverage is arguably even more risky than that built in to the DNA of spread betting as a transaction, given that the leveraged portion has to be paid back and accounted for with interest.

The overall impact of leverage is to speed up the trading cycle, and to maximise both profits and losses through trading with larger proportionate stakes. As such, leverage can be seen as the classic double-edged sword – on the one hand, it can deliver wild returns in a matter of minutes that would simply be unattainable in more traditional markets, while on the other it can rip the rug from underneath your feet and cost you your trading livelihood in no time at all, as a result of one or two bad decisions.

Key to tackling the threats and opportunities posed by leverage is understanding, and a working knowledge of both the advantages and disadvantages this leverage effect can bring.

Advantages

Improved Rate of Return
Speed of Return

Disadvantages

Losses Quickly Build up
Possible Run-away Losses

Managing Leverage Risk in Spread Betting

Key to striking the right balance between the positive and negative aspects of leverage is the ability to manage your risk exposure, both in terms of the positions you choose and the amount you stake on each trade. Part of the holy grail of successful spread betting lies in determining when to leverage up, and when to take a modest exposure, and there are a variety of techniques and strategies in spread betting that can be deployed to manage risk in the most efficient and pragmatic ways possible.

While much of the day to day, transactional business of spread betting is fast paced and operational, it pays not to lose sight of the end game. Remember that very few successful traders ever made it big with that home run trade – you don’t need to hit it out the park every time to be successful. When you adopt a longer term mindset, you can start to accept individual losses when they inevitably rise, safe in the knowledge that your aggregate trading portfolio should increase through shrewd trading. To simplify, you can trade profitably 20% of the time and still make money, so long as your 20% of successful trades earn more than the 80% of failures. Key to this is the notion that losses should be cut and profits allowed to run to their conclusion.

While it feels counter-intuitive and somehow more risky to leave a profitable position running, this really is key to helping make up ground on the inevitable losses you will sustain. By adopting a more clinical approach to nipping losing trades in the bud before they gain too much momentum, you can help minimise your losses, to give yourself the best chance of profiting overall. When you do strike it lucky with a successful position, milk it for every last point you can – while it takes nerves of steel to hold out, this is the only credible way of strengthening your account and ensuring you generate an aggregate profit from your trading activities.

Leverage in the round is arguably the single most important topic when it comes to spread betting, aside from understanding the fundamentals of how transactions work, in order to give the best feel for .

While you will no doubt experience both the positive and negative effects of leverage on your trading account as you go, it is nevertheless important to constantly bear in mind the risks inherent in leveraged trading, and the impact these risks can have on your ultimate success or failure as an investor.

2023-04-01T13:20:55+00:00

Leverage is the force in trading that enables traders to take exposure to artificially amplified transaction sizes, in order to make more money from each individual transaction. Imagine the scenario where you’re buying shares, with a view to becoming a professional share dealer. Without a massive amount of starting capital, it’s likely to take you some time before you’re in a position to generate anywhere near a full-time income. Markets simply don’t move enough in the day to make that feasible for those with less than 6-figure capital amounts to play with.

Leverage, however, makes up the difference on individual trades, which in turn makes it easier for traders to take a profit. Naturally, as with anything with the potential to return substantial gains, increasing the leverage portion of any transaction also makes things a whole lot riskier, and the difficulties leverage can pose when it starts to work against you are vast.

How Does Leverage Work?

Leverage is effectively just a short-term, notional loan. It is notional in the sense that you don’t physically receive a loan – it’s simply an automatic credit line extended by your broker in respect of your forex trades. This will normally be comprised of a degree of security money, known as margin, which usually accounts for a certain ratio of the trade, with the remainder being comprised of leverage funding.

Instead of transacting at 100% of your exposed capital, as is always the case when trading 1:1, leverage enables trading at many thousands of percent of your exposed capital, on the proviso that you return the leveraged portion when the transaction closes. Don’t worry – this is automatic. This effectively means you get to keep the earnings on thousands of pounds for every $100 you actually risk. While the losses are correspondingly significant, the effect of leverage is to effectively up the ante, and in the process it works extremely efficiently.

Leverage And Forex

In forex trading, the degrees of leverage on offer put other instruments to shame. Whereas some derivatives may offer around 20:1 leverage, forex can be traded with rations in the hundreds to one, and as a result leverage is arguably more central to forex trading than to other instruments. With other products, the markets traded are usually sufficiently volatile to make smaller degrees of leverage more workable. However, given the greater magnitude of factors required to shift currency pricing, the need for higher degrees of leverage is even greater in order to help traders grind out a return. That said, the extent of leverage at play in forex is enough to have helped countless traders both find and lose their fortunes in the global currency markets.

So leverage is a term you’re likely to come across on a frequent basis throughout this tutorial and elsewhere. To summarise its importance, leverage is the magnifying glass that makes your positions appear bigger than they are to enable larger earnings than would otherwise be possible. While this naturally means a more expansive risk profile, when used correctly it can be the forex trader’s best friend.

Advantages of Leverage in Forex

When it comes to really upping the stakes with forex, it’s leverage that is capable of doing the most damage. By blowing up position sizes to beyond where they naturally ought to be, leverage equips traders with facilities that mimic the effect of risking more capital, and this delivers a whole host of benefits and advantages to those traders capable of taming the wild beast that leverage can be. But what exactly are these key advantages, and how do they intersect to make leverage worthwhile for forex traders?

Increase Profit

The first and by some way most important benefit of trading on leverage is that it earns you more money for less effort. No matter what the instrument that’s being traded, no matter whether you’re staking a small amount or a large amount, the key role of leverage is to increase your profit from each available transaction by multiplying the stakes. The same effect could be achieved by investing more capital in each position, but leverage works to ensure it’s always one step ahead in artificially boosting your available capital – often by many hundreds of times.

No matter the intricacies and the finer points of why leverage matters, don’t let anyone tell you that leverage plays a different role for them – primarily, it’s all about making more money for the same research work and simply raising the stakes without tying up more of your precious capital.

Increase Capital Efficiency

At the same time, increasing the amount of money you can earn per transaction naturally increases the efficiency with which you are using your capital. To get all technical for a moment, consider your capital as an asset with the ability to deliver a yield. If it takes you two days to generate a $100 with unleveraged positions, leveraging up will mean it takes a much shorter period of time to earn that same $100, meaning your capital can be re-invested more times over and used to deliver the most frequent and ultimately the most significant yield it possibly can. From the point of sheer capital efficiency, leverage makes a massive impact and ensures not only greater profits in the short-term, but also a much more considerable return on investment over a much shorter time period.

Mitigate Against Low Volatility

Another key advantage of leverage as far as forex trading in particular is concerned is that it has the effect of mitigating against low volatility. Volatile trades are often those that deliver the greatest degrees of profit, because the markets are moving in wider cycles than more stable instruments. In the forex markets, primarily because of the cautious nature of the parties trading currency and the small range of factors which can externally indicate currency price adjustments, volatility tends to be towards the lowest end of the scale. This is where leverage comes to the rescue – by delivering larger profits from smaller transaction sizes, leverage has the effect of mitigating against the throttling effect of low volatility. With highly leveraged positions, even small movements can start to become seriously important, and in that sense, leverage enables traders to capitalise on less significant degrees of movement in market pricing.

Leverage is the original double-edged sword. When its working for you, it’s really working for you. But when it turns against your position, it can do serious damage in the blink of an eye. As a result, let’s now turn to look at the disadvantages as we scratch the surface of the type of damage that leverage can do.

Disadvantages Of Leverage In Forex

Most traders who have experienced terminal problems with their accounts have dabbled unsuccessfully with leverage. Most of them will have gotten a little too greedy for their capital to bear, of will simply have made a few critical mistakes along the way. The power of leverage works equally in both directions, whether that happens to be for or against your position, and understanding exactly what impact it can have on your portfolio is the first step towards mitigating against the threats it poses. But how do the risks of leverage factor in to determining how best to deploy your capital?

Heavier Losses

First and foremost, leverage is a nuisance because it paves the way for heavier losses. A 0.1% loss on a notional $20,000 at a leverage of 100:1 position (a loss of $20) feels like much more like a 10% loss when you are only exposing $200 to the position in the first place. The effect of leverage is to simply up the ante, so that in effect you’re playing with more money. When all’s said and done you keep the profits but you also bear the losses, and in this respect, leverage can end up costing you a lot more than you bargained for when positions inevitably from time to time head south.

Leverage As A Constant Liability

Furthermore, leveraging part of any transaction builds in an immediate liability that must be met by your account at the end of the day. No matter whether a transaction is up or down, no matter how many additional costs you’ve paid, the principal cost of the leverage must be met and will be automatically applied from your account. This effectively means that by entering into a position you are by default handicapped, having the automatic liability of the leverage portion to meet at the close of the transaction. Even if the transaction ultimately trends towards zero, the leverage amount is still owed and must still be paid before you can move forward.

Financing Costs

As if these troubles weren’t significant enough, any leverage funding that is applied to your positions must also be paid for in terms of interest. Interest is calculated and applied on a daily basis depending on the relevant rate as set by your broker. These costs are obviously all the more applicable with the high degrees of leverage involved in forex transactions, and the costs can mount up to act as a disincentive for holding exposure long term.

Margin Call Risk

At the same time, there remains the ever-present risk that you will fall below the margin requirements established by your broker. This is the set percentage of any transaction size you are required to fulfil in terms of your own capital, and if you fall below that threshold at any point, you can expect your broker to instigate the margin call, which will automatically liquidate your portfolio as far as meeting your obligations is concerned. This means that positions that might run on to deliver vast profits are closed out early (posing extensive and unavoidable opportunity cost) in addition to liquidating losing positions that might recover. Ultimately, this is a constant risk that is posed by the presence of leverage, and something you should take care in managing your capital to avoid.

While there are clearly a number of disadvantages to using leverage, it is important not to be put off leverage and leveraged trading on the whole. Generally speaking, leverage is considered a good thing, and particularly in forex markets where it makes up for a lack of volatility, it is essential for allowing quick yields.

2021-09-25T01:12:23+00:00