Understanding Contracts for Difference: Leverage and Margins

By Sarah Abbas

2024 January 25

Contracts for Difference (CFDs) have become very popular in financial markets as they allow traders to speculate on the price movements of underlying assets without owning them. The risk accompanying trading CFDs comes with using leverage and margins, as these tools can amplify potential gains and risks. This is why it’s crucial to understand how leverage and margins function and their positive and negative impacts in CFD trading.

This article will delve into the intricacies of Contracts for Difference, providing a comprehensive understanding of the complexities of leverage and margins to empower traders for maximum gains.

What Are Contracts for Differences (CFDs)?

Before we go deeper into the rabbit hole of margins and leverage, we’ll have a quick recap of what CFDs are. Contracts for Difference, or simply CFDs, are contracts between a buyer and seller based on an underlying asset's price movement. However, unlike traditional investing, CFD traders do not own this underlying asset.

Each ‘contracting’ party thus agrees to exchange the ‘difference’ in the asset's value from when the contract opens to when it closes. Traders predict whether an asset’s price will rise or fall. Based on the speculation, traders can either buy (go long) or sell (go short). The result of the prediction will dictate whether traders gain a profit or experience a loss.

The ability for traders to use leverage and margin in trading has made Contracts for Difference an attractive option. Let’s see what they are all about.

What Is Leverage in CFDs?

To put it simply, imagine that leverage is like a loan. For example, if you wish to open a $3,000 position in an asset that is going up but only has $100 as capital, leverage can enable you to control a more significant position than your available funds. This way, your broker will provide you with an additional $2,900. Thus, your broker will enable you to open a position 30x greater than your initial capital.

How Does Leverage Work?

Leverage operates by using a deposit, known as margin, to offer increased exposure to an underlying asset. This is where leverage appears attractive to traders, for the initial funds needed can be minimal. So, the increased exposure your broker provides is known as ‘exposure,’ and the initial capital is known as a ‘margin.’ The total exposure compared to the margin is known as the leverage ratio.

Therefore, leverage is often expressed as a ratio. For instance, a 10:1 leverage signifies that traders multiply their initial capital by 10. For example, leveraging a $1,000 at a 10:1 ratio enables you to open a $10,000 position, and so on. You can check here the type of leverage and ratios we provide based on the asset class.

However, the accompanying risk with Contracts for Difference leverage lies in that the total profit or loss is calculated on the leveraged position, not the margin amount. Let’s take the following example:

  • Let’s say you open a $10,000 position at a 10:1 leverage ratio with a margin of $100 on a specific asset.

  • Gains and losses are calculated based on the entire $10,000 position, not the $100 margin.

  • Let’s say you went long on your trade, and the underlying asset’s value increases by 30%.

  • If you close your position, you will make a $3,000 profit. This is 3x the initial margin amount of $1000.

However, if you went long on your trade and the opposite happens, such as a drop in the asset’s value by 30%, you will lose $3,000, which is also 3x the margin.

This is where the risk lies when leveraging a trade. Thus, while leveraging can amplify your trading profits, it can also amplify your losses

How to Minimise Leverage Risk

Minimizing Contracts for Difference (CFD) leverage risks is crucial for responsible trading. Here are several strategies to help mitigate the risks associated with leverage:

  • Learn How Leverage Works: The first step before venturing into any trade is to educate yourself. Understanding how leverage works in Contracts for Difference trading is critical to making informed decisions.

  • Trade at a Low Leverage: High leverage can ensure maximum profits but also amplifies losses. Consider lowering the leverage you take to reduce any risk. A good leverage ratio to start from could be 2:1.

  • Set Stop-Loss Orders: Set stop-loss orders to limit potential losses and regularly reassess your risk management strategy

  • Use a Demo Account if You’re New: New traders can get excited about venturing into a high leverage trading when starting with Contracts for Difference; the right thing to do is to practice trading with a demo account before using real money.

  • Keep an Eye on Margin Levels: Monitor margin levels to avoid margin calls (more on that below).

  • Understand Market Conditions: Stay informed about market conditions and events that may impact your trading assets.

Pros and Cons of Leverage

Considering the info we discussed above, Let’s recap the pros and cons of leverage that traders need to consider before getting into contracts for difference. The advantage of leverage is that it allows traders to amplify their profits by controlling more significant positions with a smaller capital. However, on the other side, CFD leveraging can increase the risk of significant losses as a minor market fluctuation can lead to substantial financial setbacks.

What Is Margin in CFDs?

Now, you might know what a margin is when dealing with Contracts for Difference. Let’s have an in-depth look at what a margin is. A CFD margin is the initial deposit traders must have in their trading account to open a position. The margin acts as a security deposit, ensuring traders have sufficient funds to cover their losses. In the case of leverage, the margin acts as a percentage of the total position size.

Margin Requirements

Brokers often request a minimum amount of capital that traders must maintain in their trading accounts to open and sustain leveraged positions. This is known as the ‘margin requirement’. Margin requirements are often expressed as a percentage of the total position size. For instance, if the margin requirement is 10% and you want to open a $5,000 position, you need to have $500 in your trading account as a margin. Higher leverage ratios often result in lower margin requirements. These requirements vary depending on the broker and the financial instruments being traded.

Margin Calls

A margin call is another term you must know when dealing with Contracts for Difference. A margin call is a demand from a broker to a trader compelling them to add additional funds to their traded account when the position is at risk of being closed.

For instance, let’s say you opened an account with a margin requirement for a specific asset at $1,000. You’ve only deposited the minimum margin of $1,000. If the value of the asset drops and your position sits at -$100, then you’ll have $900 equity in your account. This amount is less than the margin requirements, so the position is at risk of being closed.

The broker then initiates a margin call that urges the trader, in this case, you, to add additional funds to your account to keep the margin at the minimal required amount. You can consider it as an alert from the broker.

The Risks of Contracts for Difference Leverage

In conclusion, while Contracts for Difference (CFD) leverage allows traders to amplify their profits, it equally amplifies the significant risks that traders must consider. Traders must recognize that the appeal of leverage comes with an obligation to trade responsibly. Traders must implement effective risk mitigation strategies to trade CFDs with a high profit successfully. On the other hand, CFD leverage offers the advantage of amplifying profits, diversifying portfolios across various assets, and controlling more significant positions with small capital. Just keep in mind the risks accompanied by using leverage. Happy trading!

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