In the last decade, CFD trading has become extremely popular among retail traders looking for new ways to get exposure to the financial markets over the short term, especially the Forex and indices markets, as there are low barriers to entry and CFDs offer great flexibility for traders.
However, CFD trading can be a risky trading technique if not properly understood and used, as it relies on leverage and margin trading. While leverage can be a great way to potentially make a greater profit, it also potentially leads to more losses if you’re wrong. Let’s have a look at how to best use leverage and margin trading with CFDs in your strategy.
What are CFDs?
The first thing to know to determine if you should trade CFDs is if they fit your trader profile. For that, you need to truly understand what CFDs are and what they imply for your trading.
CFDs, or Contracts for Difference, are financial derivatives used to trade the price change of an underlying asset (a currency, stock, commodity, index, bond, ETF) without owning it. They act like financial contracts between you and your broker to exchange the difference in price between the opening and the closing values of the traded asset. CFDs are great options to trade upward and downward price movements. As CFD trading is based on leveraged and margin trading, you also must understand how leverage and margin work in trading.
What is leverage and margin trading?
When using leverage and margin trading with CFDs, you’re basically borrowing money from your broker to invest more than what you could invest with the funds in your trading account. To allow you to use borrowed funds, your broker will require you to put aside a kind of collateral, called “margin”. Usually, the margin is a fixed amount or a percentage of the value of your position and depends on the underlying asset, your broker’s policies, as well as the size of your position.
This is an easy example to understand leverage and margin in trading:
Let’s say that you want to buy 1,000 shares of stock A at a price of $10 per share. If you don’t use leverage, you will have to pay upfront $10,000 to be able to buy 1,000 shares A. But if you use leverage, you can open that position with a smaller initial investment.
If you use a leverage of 1:10, you will be able to invest $10,000 with only $1,000 (10,000/10) (your broker will be the one providing the remaining $9,000 as a kind of loan). If you use a leverage of 1:5, you will be able to invest $10,000 with $2,500 in your account (10,000/5) and your broker will provide the remaining $7,500.
These $1,000 or $2,500 figures might be considered your margin (but you’ll need more funds in your trading account to be able to hold your position, depending on your broker’s margin requirements).
Advantages of using leverage and margin trading
- This may lead to higher profits.
- You can start with a small amount of trading capital and profit from increased trading power.
- Reduced overall trading costs (depending on your trading style).
- Greater flexibility in your trading strategies.
- Better diversification with the associated financial products and markets.
- Possibility to use short selling with some financial products like CFDs to profit from price falls.
- Accessibility of financial markets that could otherwise be used solely by professional traders.
Risks of using leverage and margin trading
- This may lead to higher losses.
- Higher market volatility.
- Potential margin calls when the markets go against you if you’re not able to maintain a certain level of margin in your trading account.
- Higher borrowing cost if you keep your position open for more than 1 day (overnight costs or rollover associated with the borrowed funds).
Now that you understand that leverage and margin trading through CFDs can be risky, you have to manage your risk level carefully to avoid taking unnecessary risks with your trading capital and maximize your potential profits.
That’s why the first thing you need to do is to use leverage judiciously. Do not use maximum leverage just because you have access to it in your CFD account. Consider your trading plan, your risk appetite, your education and knowledge about finance and trading, as well as the overall market conditions and volatility to decide the right level of leverage you should use in your trading right now.
It’s also important to monitor your margin to maintain sufficient funds to avoid margin calls that occur when the required margin drops below a certain threshold, not allowing you to keep your current trades open. Margin calls usually require you to deposit more funds to cover your open losing positions, otherwise, your broker might close them. So, always monitor your trading positions closely and be ready to adjust them in response to market changes, so you can better manage your risks.
Finally, you have to control your emotions and be disciplined to always stick to your trading plan, as well as your money/risk management rules. Always have a clear and specific strategy to follow for entering and exiting trades, and always use stop-loss orders to limit potential losses.