What is Leverage in CFD Trading and Why is it so Important

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What is a contract for difference?

A contract for difference (CFD) is a popular form of derivative trading. CFD trading enables you to speculate on the rising or falling prices of fast-moving global financial markets (or instruments) such as shares, indices, commodities, currencies and treasuries.

CFD trading explained

Some of the benefits of CFD trading are that you can trade on margin, and you can go short (sell) if you think prices will go down or go long (buy) if you think prices will rise. CFDs are tax efficient in the UK, meaning there is no stamp duty to pay*. You can also use CFD trades to hedge an existing physical portfolio.

Introduction to CFD trading: how does CFD trading work?

With CFD trading, you don’t buy or sell the underlying asset (for example a physical share, currency pair or commodity). You buy or sell a number of units for a particular instrument depending on whether you think prices will go up or down. We offer CFDs on a wide range of global markets and our CFD instruments includes shares, treasuries, currency pairs, commodities and stock indices such as the UK 100, which aggregates the price movements of all the stocks listed on the FTSE 100.

For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss.

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What is margin and leverage?

CFDs are a leveraged product, which means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’ (or margin requirement). While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the CFD position.

What are the costs of CFD trading?

Spread: When trading CFDs you must pay the spread, which is the difference between the buy and sell price. You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favour before you start to make a profit, or if the price moves against you, a loss. We offer consistently competitive spreads.

Holding costs: at the end of each trading day (at 5pm New York time), any positions open in your account may be subject to a charge called a ‘holding cost’. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate.

Market data fees: to trade or view our price data for share CFDs, you must activate the relevant market data subscription for which a fee will be charged. View our market data fees

Commission (only applicable for shares): you must also pay a separate commission charge when you trade share CFDs. Commission on UK-based shares on our CFD platform starts from 0.10% of the full exposure of the position, and there is a minimum commission charge of £9. View the examples below to see how to calculate commissions on share CFDs.

Please note: CFD trades incur a commission charge when the trade is opened as well as when it is closed. The above calculation can be applied for a closing trade; the only difference is that you use the exit price rather than the entry price.

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What instruments can I trade?

When you trade CFDs with us, you can take a position on over 10,000 CFD instruments. Our spreads start from 0.7 points on forex pairs including EUR/USD and AUD/USD. You can also trade the UK 100 and Germany 30 from 1 point and Gold from 0.3 points. See our range of markets

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Example of a CFD trade

Buying a company share in a rising market (going long)

In this example, UK Company ABC is trading at 98 / 100 (where 98pence is the sell price and 100pence is the buy price). The spread is 2.

You think the company’s price is going to go up so you decide to open a long position by buying 10,000 CFDs, or ‘units’ at 100 pence. A separate commission charge of £10 would be applied when you open the trade, as 0.10% of the trade size is £10 (10,000 units x 100p = £10,000 x 0.10%).

Company ABC has a margin rate of 3%, which means you only have to deposit 3% of the total value of the trade as position margin. Therefore, in this example your position margin will be £300 (10,000 units x 100p = £10,000 x 3%).

Remember that if the price moves against you, it’s possible to lose more than your margin of £300, as losses will be based on the full value of the position.

Outcome A: a profitable trade

Let’s assume your prediction was correct and the price rises over the next week to 110 / 112. You decide to close your buy trade by selling at 110 pence (the current sell price). Remember, commission is charged when you exit a trade too, so a charge of £11 would be applied when you close the trade, as 0.10% of the trade size is £11 (10,000 units x 110p = £11,000 x 0.10%).

The price has moved 10 pence in your favour, from 100 pence (the initial buy price or opening price) to 110 pence (the current sell price or closing price). Multiply this by the number of units you bought (10,000) to calculate your profit of £1000, then subtract the total commission charge (£10 at entry + £11 at exit = £21) which results in a total profit of £979.

Outcome B: a losing trade

Unfortunately, your prediction was wrong and the price of Company ABC drops over the next week to 93 / 95. You think the price is likely to continue dropping so, to limit your losses, you decide to sell at 93 pence (the current sell price) to close the trade. As commission is charged when you exit a trade too, a charge of £9.30 would apply, as 0.10% of the trade size is £9.30 (10,000 units x 93p = £9,300 x 0.10%).

The price has moved 7 pence against you, from 100 pence (the initial buy price) to 93 pence (the current sell price). Multiply this by the number of units you bought (10,000) to calculate your loss of £700, plus the total commission charge (£10 at entry + £9.30 at exit = £19.30) which results in a total loss of £719.30.

Short-selling CFDs in a falling market

CFD trading enables you to sell (short) an instrument if you believe it will fall in value, with the aim of profiting from the predicted downward price move. If your prediction turns out to be correct, you can buy the instrument back at a lower price to make a profit. If you are incorrect and the value rises, you will make a loss. This loss can exceed your deposits.

Hedging your physical portfolio with CFD trading

If you have already invested in an existing portfolio of physical shares with another broker and you think they may lose some of their value over the short term, you can hedge your physical shares using CFDs. By short selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio.

For example, say you hold £5000 worth of physical ABC Corp shares in your portfolio; you could hold a short position or short sell the equivalent value of ABC Corp with CFDs. Then, if ABC Corp’s share price falls in the underlying market, the loss in value of your physical share portfolio could potentially be offset by the profit made on your short selling CFD trade. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again.

Using CFDs to hedge physical share portfolios is a popular strategy for many investors, especially in volatile markets.

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Not Understanding CFD Leverage

Investors are attracted to CFDs because of the leveraged opportunities they offer, the low initial capital required to commence trading and the perceived ease of trading. However, most investors are oblivious to the risks of CFDs and lack a real understanding about the impact of leveraging and how it can devastate them and this misunderstanding is at the centre of CFD risk.

It’s a pity, but some people are attracted by exaggerated claims of the fortunes that can be made trading contracts for difference, and never learn how to use their accounts safely before they lose all their money. These are the friends who tell you that, overall, they just break even or are just slightly profitable over time. While many see large returns on individual trades, these are counterbalanced by losses on others and CFDs are unlikely to meet the investment needs and objectives of all retail investors.

CFDs can be defined as high-risk derivative instruments typically used by sophisticated traders to take geared, short-term positions in volatile markets. Leverage is the one big attraction, and risk, of trading contracts for differences. Trading shares on margin via CFDs requires less cash than the equivalent share purchase, but you are still exposed to the same absolute profit and loss. Many investors will tell you that trading a derivative like a contract or difference is risky and for the most part they are right. You only have to deposit a fraction of the value of the shares, forex or commodities that you buy. If you buy a share CFD, putting up 10 per cent of the value, you make a 100 per cent profit if the shares go up just 10 per cent. Similarly, if the shares fell 10 per cent, you would lose your whole starting amount. That’s 10 times the gain or loss compared with purchasing the stocks themselves. What most people miss is that you control the gearing or leverage which implies that you have control on the risk.

Education: The Power of Leverage

The capacity to make a gain from small percentage moves on a share, forex pair or index is because of one important thing; the power of leverage. The leverage level offered by the CFD broker magnifies the underlying movement of the share, which can be both positive and negative.

A key benefit of CFDs is the ability to trade securities on margin i.e. ability to gain exposure to a share, index or currency contract with a relativel small capital outlay. As opposed to having to pay for the full notional value of the CFD contract, investors can enter into positions with margins as low as 5 to 10%. This gives CFD traders a greater exposure than can be achieved by trading traditional, non-leveraged securities. However, it is important to note that even though a smaller initial deposit is needed to open the trade, you are still exposed to the price movement of the share CFD for the full notional worth of the position. In other words, despite a smaller commitment of capital, the CFD trader still acquires exposure to the impact of price swings for and against the full face-value of the trade.

Trading a CFD at 10% margin is equivalent to leveraging your exposure by 10 times, so a $10,000 deposit might allow you to open positions for up to $100,000. This in turn means that small fluctuations in price might result in much larger gains but this also works in reverse – losses can also be magnified if the price moves against your position. For instance when trading a CFD with a margin of 5%, a price rise of 2% of the underlying asset may result in gains of 20% – but if the price fell by 2%, this might lead to a loss of 20% of the amount you deposited to open the position.

First and most obvious it is important to gain an exhaustive understanding of all the facets of CFDs and the leverage effect they can offer via the margin feature – which cuts both ways; leveraging your trading capital in this way can either work for you or against you. The concept of leverage, or gearing, of your account is one that many people find difficult to understand, but it is essential to become educated before committing real funds. CFDs are essentially a leveraged bet on future changes in the market price.

Many CFD traders look only at the extra buying power that leverage makes available to them. They make the mistake of ignoring the fact that leverage is a double-edged sword. Why on earth would anyone want to trade financial products that could potentially wipe you out? Here is a naive perspective of a common investor without an understanding of leverage mechanics looking at this:

If Dave invested $10,000 of his savings into the stock market by buying shares and it went up 10% he’d make $1,000. Big deal. If Dave on the other hand put in $10,000 of his savings into CFDs and it went up 10% he’d make $10,000. Big deal!!

Leverage Effect

Perhaps the most familiar comparison that can be drawn is with buying a house with a mortgage. Most people understand that they can buy a house by putting 10% or 20% down, and borrowing the rest of the money on a mortgage which they pay back over a period of years. Until the housing bubbles of recent years, this has been considered an extremely safe and profitable way of using your money. You could buy a house worth $200,000 by paying only $20,000 as a deposit and making payments of $1000 per month. When the value of the house rose by 10%, you “made” $20,000 on your initial investment of $20,000.

The housing bubble represents what can happen when you trade CFDs. Leverage is a good thing if you are making good trades, but a terrible thing if you trade badly and do not know about money management. Newcomers to CFD trading sometimes took the same view as buyers of real estate used to, and believed that prices would never go down. As prices go down, and as CFDs go down, you can end up owing more than you have available. With houses, it’s known as being underwater, or upside down on your mortgage, and with CFDs you get wiped out.

That’s the simplest way to understand how leverage can work against you as well as for you. With houses, it was sometimes difficult to find a buyer as the value fell, and in any case people needed somewhere to live and didn’t want to sell. With CFDs, how much you lose is under your control, because in a losing position you can choose the moment that you sell. If you wish to keep your risk to a bare minimum you can trade CFDs with no leverage and treat your account like a share dealing account. So with $20,000 cash in your trading account, you would take positions not exceeding $20,000.

Because of the way leverage works, CFD traders need fully to understand the risks and costs involved. Gains and losses are based on the full contract value once the trade is closed. This means that on the positive side, profits can be significantly greater than the initial deposit outlay required to setup the trade. On the negative side, the loss can also be considerably larger than the original cash outlaid when entering the trade.

In practice there are two things that govern and control your losses. One is the price, less than your entry price that you decide will tell you your trading idea didn’t work. The other is the amount that you put into the trade. By looking at the two of these together, you can see how much money you could lose. To trade safely, you should set a limit that you are prepared to lose on a trade, and many traders set this at 2%. You can then work backwards to see what the most is that you should put in a particular trade.

If you aren’t comfortable with the level of leverage you are utilising on a trade, then simply cut back. Some CFD providers like IG Markets offer mini contracts on certain markets, so if you feel anxious about what effect the movement of one point against your position will have on your running profit or loss, then you an simply cut back the size of the trade. As David Jones of IG Markets puts it ‘It is difficult enough to get market direction right without getting stressed by every small move in the market’.

There is nothing wrong with CFDs – the problem is with the way investors use them. For such a turbocharged product you really need to know what you are doing but instead some people are clicking past all those terms and conditions without reading a word – Marcus Padley, Patersons Securities

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Reading time: 13 minutes

If you are a rookie trader, you may find yourself asking questions such as ‘what is leverage in Forex trading?’ and ‘how can it be useful?’ This article will provide you with answers to these types of questions, together with, a detailed overview of Forex leveraging, its advantages and disadvantages, and a list of possible applications and restrictions.

What is Leverage?

In general, leverage enables you to influence your environment in a way that multiplies the outcome of your efforts without increasing your resources.

In the world of trading, it means you can access a larger portion of the market with a smaller deposit than you would be able to via traditional investing. This gives you the advantage of getting greater returns for a small up-front investment, though it is important to note that traders can be at risk of higher losses when using leverage. In finance, it is when you borrow money, to invest and make more money due to your increased buying power. Once you return what you borrowed, you are still left with more money than if you had just invested your own capital.

Let’s look at it in more detail for the finance, Forex, and trading world.

What is Financial Leverage?

Leverage in finance pertains to the use of debt to buy assets. This is done in order to avoid using too much equity. The ratio of this debt to equity is the formula for leverage (debt/equity ratio) whereby the greater the proportion of debt, the higher the amount of leverage. If a company, investment or property is termed as “highly leveraged” it means that it has a greater proportion of debt than equity. When leveraged debt is used in such a way that the return generated is greater than the interest associated with it, then an investor is in a favourable position.

However, an excessive amount of economic leverage it is always risky, given that it is always possible to fail to repay it.

(Note that the leverage shown in Trades 2 and 3 is available for Professional clients only. A Professional client is a client who possesses the experience, knowledge and expertise to make their own investment decisions and properly assess the risks that these incur. In order to be considered to be Professional client, the client must comply with MiFID ll 2020/65/EU Annex ll requirements.)

Financial leverage is quite different from operating leverage. Operating leverage of a business entity is calculated as a sum total of the amount of fixed costs it bears, whereby the higher the amount of fixed costs, the higher the operating leverage will be. Combine the two and we get the total leverage. So, what does leveraging mean for a business? It is the use of external funds for expansion, startup or asset acquisition. Businesses can also use leveraged equity to raise funds from existing investors.

Why Use Financial Leverage?

Leverage is used for these basic purposes:

  1. To expand a firm’s or an individual’s asset base and generate returns on risk capital. This means that there is an increase in ROE and Earnings Per Share.
  2. To increase the potential of earnings.
  3. For favourable tax treatment, since in many countries, the interest expense is tax deductible. So, the net cost to the borrower is reduced.

Leveraged Equity

When the cost of capital debt is low, leveraged equity can increase returns for shareholders. When you own stock in a company that has a significant amount of debt (financial leverage), you have leveraged equity. It entails the same amount of risk as leveraged debt. Therefore, the stockholder experiences the same benefits and costs as using debt.

Trading Leverage

Trading leverage or leveraged trading allows you to control much larger amounts in a trade, with a minimal deposit in your account. Leveraged trading is also known as margin trading. You can open up a small account with a brokerage, and then essentially borrow money from the broker to open a large position. This allows traders to magnify the amount of profits earned.

Remember, however, that this also magnifies the potential losses. Stock market leverage includes trading stocks with only a small amount of trading capital. This is also seen in forex leveraging, wherein traders are allowed to open positions on currency prices larger than what they can afford with their account balance alone.

It should be remembered that leverage does not alter the profit potential of a trade; but instead, reduces the amount of equity that you use. Leveraged trading is also considered a double-edged sword, since accounts with higher leverage get affected by large price swings, increasing the chances of triggering a stop-loss. Therefore, it is essential to exercise risk management when it comes to leveraged instruments.

What is Leverage in Forex?

Financial leverage is essentially an account boost for Forex traders. With the help of forex leveraging, a trader can open orders as large as 1,000 times greater than their own capital. In other words, leverage is a way for traders to gain access to much larger volumes than they would initially be able to trade with. More and more traders are deciding to move into the FX (Forex, also known as the Foreign Exchange Market) market every day.

Trading currencies online is an exciting experience, and is accessible for many traders, and while each person will have their own reasons for trading in this market, the level of financial leverage available remains one of the most popular reasons for traders choosing to trade on the FX market.

When visiting sites that are dedicated to trading, it’s possible that you’re going to see a lot of flashy banners offering something like ” trade with 0.01 lots, ECN and 500:1 leverage”. While each of these terms may not be immediately clear to a beginner, the request to have Forex leverage explained seems to be the most common one.

Although we defined leverage earlier, let’s explore it in greater detail:

Many traders define leverage as a credit line that a broker provides to their client. This isn’t exactly true, as leverage does not have the features that are issued together with credit. First of all, when you are trading with leverage you are not expected to pay any credit back. You are simply obliged to close your position, or keep it open before it is closed by the margin call. In other words, there is no particular deadline for settling your leverage boost provided by the broker.

In addition, there is also no interest on leverage, instead, FX Swaps are usually what it takes to transfer your position overnight. However, unlike regular loans, the swap payments can also be profitable for a trader. To sum up, leverage is a tool that increases the size of the maximum position that can be opened by a trader. Now we have a better understanding of Forex trading leverage, let’s see how it works with an example.

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How Does Forex Leverage Work?

Let’s say a trader has 1,000 USD on their trading account. A regular lot of ‘1’ on MetaTrader 4 is equal to 100,000 currency units. As it is possible to trade mini and even micro lots with Admiral Markets, a deposit this size would allow a trader to open micro lots (0.01 of a single lot or 1,000 currency units) with no leverage put in place. However, as a trader would usually be looking for around 2% return per trade, it could only be equal to 20 USD.

This is why many traders decide to employ gearing, also known as financial leverage, in their trading – so that the size of the trading position and profits could be higher. Let’s assume a trader with 1,000 USD on their account balance wants to trade big and their broker is supplying a leverage of 1:500. This way a trader can open a position that is as large as 5 lots, when it is denominated in USD. In other words, 1,000 USD * 500 (the leverage), would equal a maximum size of 500,000 USD for the position. The trader can actually request their orders of 500 times the size of his deposit to be filled.

This way, if 1:500 leverage is used, a trader would be making 500 USD instead of 1 USD. It is of course important to state that a trader can lose the funds as quickly as it is possible to gain them. Now as we have understood the definition and a practical example of leverage, let’s take a more detailed look at its application, and find out what the best possible level of gearing in FX trading is. Admiral Markets offers varying leverages which are dependent on client status via Admiral Markets Pro terms.

For retail clients, leverages of up to 1:30 for currency pairs and 1:20 for indices are available. For professional clients, a maximum leverage of up to 1:500 is available for currency pairs, indices, energies and precious metals. Both retail and professional status come with their own unique benefits and trade-offs, so it’s a good idea to investigate them fully before trading. Find out today if you’re eligible for professional terms, so you can maximise your trading potential, and keep your leverage where you want it to be!

Which Leverage to Use in Forex

It is hard to determine the best level one should use, as it mainly depends on the trader’s strategy and the actual vision of upcoming market moves. As a rule of thumb, the longer you expect to keep your position open, the smaller the leverage should be. This would be logical, as long positions are usually opened when large market moves are expected. However, when you are looking for a long lasting position, you will want to avoid being ‘Stopped Out’ due to market fluctuations.

In contrast, when a trader opens a position that is expected to last for a few minutes or even seconds, they are mainly aiming to extract the maximum amount of profit within a limited time. What is the best forex leveraging in this case? Usually such a person would be aiming to employ high, or in some cases, the highest possible leverage to assure the largest profit is realised, while trading small market fluctuations.

From this we can see that the Forex leverage ratio strongly depends on the strategy that is going to be used. To give you a better overview, scalpers and breakout traders try to use as high a leverage as possible, as they usually look for quick trades. Positional traders often trade with low leverage or none at all. A desired leverage for a positional trader usually starts at 5:1 and goes up to about 20:1.

When scalping, traders tend to employ a leverage that starts at 50:1 and may go as high as 500:1. Knowing the effect of leveraging and the optimal leverage Forex trading ratio is vital for a successful trading strategy, as you never want to overtrade, but you always want to be able to squeeze the maximum out of potentially profitable trades. Usually a trader is advised to experiment with leverage within their strategy for a while, in order to find the most suitable one.

To learn more about why lower leverage is good for retail traders and what is the success rate for high vs. low leverage, watch this free webinar here:

FX Broker Offers

Unlike futures and stock brokers that offer limited leverage or none at all, the offers from FX brokers are much more attractive for traders that are aiming to enjoy the maximum gearing size. It is hard to indicate the size of the leverage that a Forex trader should look for, yet most of the Forex broker leverages available start at 100:1 and tend to be an average of 200:1. There are also many brokers that can supply 1:500 leverage.

Also, in very rare cases it is possible to open an account with a broker that supplies 1,000:1, however, there aren’t many traders who would actually want to use gearing at this level.

How to Change Forex Leverage

Once you begin trading with a certain FX broker, you may want to modify the leverage available to you. This depends on the broker. With Admiral Markets you can use an industry standardised procedure that includes authenticating to the Trader’s Room, selecting your account, and changing the leverage available. This action takes immediate effect, so be careful if you have open positions when you attempt to reduce your leverage.

Another important aspect to remember is that leverage is tied to the account deposit level, so sometimes when depositing extra funds into your account, currency trading leverage can be reduced. For example, a broker may supply a leverage of 1:500 on the deposits below 1,000 USD, and a leverage of 1:200 on the deposits between 1,000 and 5,000 USD.

Once a trader has 950 USD, and opens a 3 lot position on EURUSD, they may decide to deposit a bit more to sustain a required margin, yet when the deposit occurs, the leverage will be changed, and the position might close when the Stop Out level has been reached.

Conclusion

We hope that this article has been useful to you, and that by now you have clearly understood the nature of gearing, how to calculate Forex leverage, and how it can be equally be useful or harmful to your trading strategy. It is important to state that leveraged Forex trading is quite a risky process, and your deposit can be lost quickly if you are trading using a large leverage. Do try to avoid any leveraged or highly leveraged trading before you have gained enough experience.

Trade With Admiral Markets

If you’re feeling inspired to start trading, or this article has provided some extra insight to your existing trading knowledge, you may be pleased to know that Admiral Markets provides the ability to trade with Forex and CFDs on up to 80+ currencies, with the latest market updates and technical analysis provided for FREE! Click the banner below to open your live account today!

About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world’s most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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