The use of Leverage in CFDs: the Risks and Rewards
Over the years, CFD trading has become a popular investment method for Australians looking to diversify their portfolios and hone their trading skills. One key aspect of CFD trading is the use of leverage, which permits traders to open much larger positions than they normally would be able to with just their own capital.
In this article, we examine how CFD trading works, the concept of leverage, and how you can trade CFDs with the use of leverage. If you are interested in, read on.
What are CFDs?
CFD stands for Contract for Difference, and it is a type of financial derivative. CFD trading is the purchase of a contract that allows the trader to speculate on the performance of an underlying asset and potentially make a profit from asset price fluctuations. These assets include stocks, commodities, indices, and currencies. CFD traders buy these contracts from CFD providers, which are often brokers.
How CFD trading works
In CFD trading, a trader takes a long position to indicate buying, when they believe the market is bullish and prices of assets will increase. Conversely, they take a short position to indicate selling, when they believe the market is bearish and prices of assets will decrease.
CFDs do not have expiry dates unlike other contracts such as options or futures. If a trader wants to close out their position, they simply purchase another contract in the opposite direction, in the same amount. For example, a trader who goes long on 100 stocks of Company ABC wants to close out their position. They will then purchase a contract going short on 100 stocks of the same company. This closes out their position effectively.
The concept of leverage
Leverage is a sum of money a trader can borrow from their broker, that allows them to open a bigger position than their existing funds would normally allow. Brokers express leverage as a ratio, with 100:1 meaning that for every 1% of capital a trader puts down, the broker will loan them the remaining 99%. In other words, a trader investing $100 using a leverage of 100:1 can open a position worth $10,000.
As you can see, leverage is a powerful, and it can open position sizes much larger than the trader can initially afford. This is where the risks also come in. If the market moves in the trader’s favour, the profit they take will be a percentage of the total position size.
For example, if the trader buys 10 stocks at $10 each, and use a leverage of 100:1, their total position size is $10,000. If the stocks move up by $2, the trader will have earned 10 x $2 x 100 = $2,000. This dramatically increases the potential for profit for the trader. However, if the stocks drop by $2, the trader immediately loses $2,000. This exceeds the initial investment the trader makes by a substantial amount, and the broker may issue a margin call, asking the trader to deposit more funds into their account to continue trading. If the trader fails to do so, the broker closes the position.
Why traders use leverage in CFD trading
The most obvious reason why people use leverage in CFD trading is for the potential to maximise their profits. With leverage, traders with a small initial amount of capital can control a substantially larger position. This can be attractive for traders who wish to increase their buying power and significantly increase their potential returns of a trade.
Another reason is that of a lower capital requirement. With the use of leverage, traders who do not have a lot of starting capital can nevertheless participate in opening large positions or markets with higher participation thresholds. This can be a great way for traders to dip into different markets.
How to trade CFDs with leverage
If you are keen to start trading CFDs with leverage, you can do so by following the below outlined steps:
Establish a trading plan
The first thing you should do is to establish a trading plan. You should outline what you want to achieve with trading, the instruments you want to trade, and the ways in which you want to trade. You should also set up a risk management strategy that can help you prevent catastrophic losses. For example, you may decide that you will never use leverage greater than 20:1. Or you may set alerts and orders that can help you monitor the markets more efficiently.
Choose a reputable broker
Many brokers provide CFDs for their clients to trade, but they may not offer access to a full range of markets. If you want to invest in a specific market or a specific instrument, be sure to do sufficient research and pick a broker that offers it. You should also make sure your broker has all the local licenses required in Australia, such as the ASIC.
Calculate your position size
Next, when you have opened an account with a broker and are ready to get started trading, you should calculate your position size. Select the leverage ratio you would like to use, such as 20:1 or 50:1, that matches your risk appetite and is appropriate for the instrument of your choosing.
Purchase a contract
Once you have settled on an instrument you would like to trade – and how much you would like to buy or sell – you will need to purchase a contract from your CFD provider. You can do this by simply logging into your account with your broker. A contract has many different components. Some instruments also have fixed quantities when exchanged through contracts. For example, a Stock CFD may be a fixed number of 100 shares per contract. If you want to trade 500 shares, you will need to buy 5 contracts.
Use stop-loss orders
Afterwards, remember to put in place proper risk management. This can include the use of stop-loss orders, which helps you limit potential losses in the event of adverse market conditions. A stop-loss order is essentially an automatic command that helps you enter and exit positions if the market price hits a certain price or leaves a predesignated range.
Monitor your position
Once you have an open position, you should monitor it regularly to make sure market conditions are stable. You may be able to adjust your leverage as needed, to maximise your potential returns while minimising your risk.
Close your position
When you are ready to close your position and take profit, you simply need to buy another contract of the same amount for the same instrument, in the opposite direction. In other words, if you went long in your first contract, you should go short in your next one. This is because contracts for differences have no expiry date, and your position can remain open for as long as you like.
The bottom line
Leverage can be a powerful tool in CFD trading, but it does require caution. Traders should pay close attention to the markets when trading with leverage, and they should never open positions too large for them to manage. It is also advisable for traders to focus on one open position at a time, especially when using significant leverage. Remember that all forms of trading contain risks, and you should never trade with money you cannot afford to lose.