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

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What is Leverage in CFD Trading and Why it’s Important?

Updated on: 6 January 2020

There are a lot of concepts you need to get familiarized with when it comes to the trading business. As a beginner, you absolutely have to watch your steps, because entering the trading industry is literally stepping on a minefield. The competition is ruthless and the risks, as a newcomer, are extremely high.

The only way to learn how to move and prosper within its environment is to accumulate as much information as you can. Like I said, there are a ton of concepts to learn about, all being equally important in their own way. However, today we will be focusing on one of the most infamous of them – the leverage.

And I say infamous because, whether you consider it the true money-maker feature or a real harbinger of apocalyptic losses, leverage definitely has a major impact in the trading market. And you are here to learn everything you can about it.

The ABCs of CFD trading and the magic of the CFD leverage

The leverage is the main thing that attracts people towards CFD trading (Contract For Difference). Here is how it goes. In your everyday forex trading transactions, if you want to pay for an asset, you need to offer the full price. You want to purchase 1.000 shares at $3 each? Then you have to pay $3.000 for the lot.

Now, there are mainly 2 types of people that deal with classic trading options involving full buys: the rich ones and the rookies. Sure, there are pros that like to stick to that type of trading as well, but they are definitely the minority. Why? Well, I thought it was obvious. Because of the CFD trading and the leverage.

The leverage is the ability to use one asset’s full value without having to pay the asset’s full price for you to do that. So, if you want to control a $3.000 worth of an asset, all you have to do is to pay a fraction of that amount. Usually between 5% and 25% of the full price. And you borrow the rest from your broker.

Why is this fact important? Because, by doing so, your gains will be defined by the full value of the asset you are controlling, not by what you have literally invested. What this means is that you get to invest, say, 10% ($300) and your gains will be multiplied based on the asset’s real price of $3.000, instead of taking your 10% investment as a point of reference.

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I don’t think I need to explain how much money you can make off of that simple system, do I? I have been trading using leverage-based strategies for a lot of time now and I have had my ups and downs, I have to admit it. But, after being in the business for so long, I came to understand just how effective and productive this mechanism is.

Here is what I mean by that:

– You get access to otherwise inaccessible markets – Not everybody has the financial potency to risk thousands or tens of thousands of dollars on high-value markets, where usually the big sharks played. Leverage changed that, by the simple fact that you can control an expensive asset or security by only paying a percentage of its real value.

This translates by opportunity. The opportunity to operate on the same markets as the big boys and juggle with the same money they do. This, in my opinion, is one of the most seductive aspects of leverage altogether.

– The winnings multiply considerably – Since you get to control high value assets, your gains will grow depending on the asset’s real value, not what you have actually invested. This is the aspect that attracts most of the people in the CFD trading.

– Lower risk of losing your money – Think of it this way. Say you need to control a $20.000 position in the forex trading. What you need to do is to actually invest $20.000 and buy that position, right? Now, what happens if your bet fails? You lose $20.000 in one go. Nothing you can do.

With the leverage being used, if you want to control a $20.000 position, you only need to invest a percentage of the sum. Say 10%, which is $2.000. If your position fails and you close out in time, you can actually minimize the loss by a lot. You will only risk $2.000 instead of $20.000.

You don’t have to be a math genius to see the advantages.

– Raises interesting opportunities – Let’s say you have a tip regarding a major trade between two corporate giants that is bound to send ripples throughout the entire economic and financial sphere. What do you do? I bet you would be interested in acquiring some shares, right? But the problem is that the shares have already begun growing and your capital is too low.

One word – leverage. You use leverage to access a higher capital and buy as many shares as you can, thus allowing you to take advantage of an opportunity that would otherwise be inaccessible. And, trust me, it happens a lot.

This is what I personally love about CFD trading. Now, since we are here, I want to expand on some aspects. Leverage works by acquiring a margin. A lot of people are confused about the difference between the two, so I would like to clarify that aspect here, before going any further.

The margin represents the amount of money you borrow from your broker. The debt itself. The leverage is the act itself of borrowing and getting capital increase by using the margin. Think of it this way. The margin is the lever you pull and the leverage is the effect that follows.

With that out of the way, let’s focus on the least pleasant aspect of resorting to leverage trading.

How does leverage work in CFD and are there any downsides?

You will never hear about the risks of CFD leverage trading and for good reasons. He is interested in keeping you active for as much as he can, because an active trader is a profitable trader, regardless if he wins or loses. There are very few brokers that will actually break it down to you fair and square.

Which is why I am here. Call me the Voice of Reason, but I think that, as a broker, lying or hiding information from your potential clients will only help build an unflattering reputation.

So, here is what you need to know about CFD trading leverage that you don’t hear too often:

1. Capital multiplication can work against you

People tend to forget that leverage is potentially rewarding and damaging at the same time. If you get pumped at the idea of multiplying your potential gains by a factor of 10, you will surely deflate in an instant at the idea of multiplying your losses by an equal amount.

This is the nasty side of any leverage trade and it eventually bites on all traders who tend to disregard the danger and take the mechanism for granted. The notion of capital multiplication can be both seductive and scary and this is one golden rule you need to take with you each time the trading market calls.

2. It is an unreliable when the asset is extremely volatile

The risk of leverage slapping you over the face is multiplied when the asset is extremely volatile and unpredictable. Because, if you can’t determine its movement pattern or trend, the risk of losing your capital will become extremely high.

And, with leverage, you will end up even losing capital you don’t have, because of how the win-loss multiplying mechanism works.

3. The risk of losing sight of the market’s movements

With leverage, you need to be almost constantly wired to the trading market and take immediate actions when you notice that the things start going downhill. Cutting the losses is one of the main CFD trading strategies and you won’t be able to pull that off if you are not connected to the matrix nearly around the clock.

Once you have lost sight of the market, the consequences might hit you like a sledgehammer, crashing your world around you. Because, remember, with leverage, the losses could gain epic proportions quick.

Is there a way to use a safety harness?

Reader, meet Leverage Risk Management. From now on, this little guy will be your best friend. Treat him well and listen to what he has to say, because he is one smart little fella. Risk management, when dealing with leverage, is absolutely imperative. It is imperative in trading in general, I will give it that, but it is that much more important in this particular situation, when things can go haywire in the blink of an eye.

In order to prevent those unpleasant possibilities, there are certain security measures you can resort to:

1. Feel the market, become the market

I have to say, this is my personal favorite. Keeping the market under strict surveillance and analyzing trends, patterns, news and tendencies is what will get you out of a lot of problems. Prevent instead of treating, because treatments are usually more expensive and overall riskier.

And with CFD trading you need to double down on that market analysis as often as you can. When it comes to the trading business, most of the surprises are bad surprises.

2. Only get safe assets

By safe assets I mean those that are overall steadier and don’t tend to swing from one extreme to another too often. In other words, look for assets or securities with a low volatility factor.

If you are going to ignore my advice and aim for the more volatile ones, at least make sure you can predict the direction the asset will head.

3. Use stop-losses orders

This will help you exert a higher degree of control over the losses whenever the value of a certain asset goes into the wrong direction. It is a safety measure you can add to your margin account and you can and should activate it before taking on any serious engagements.

4. Don’t go multi-bidding

The more experienced traders will resort to leverage multi-bidding, placing bids for several assets at the same time. In and of itself, this bidding method isn’t necessarily bad. It gives way to a lot more profit over shorter periods of time.

But imagine what will happen if your bids fail. Imagine the financial hole you will find yourself in. It is smart to take one asset at a time, especially when you are in your trading childhood and lack the proper knowledge and skills to control the outcome of a trade.

The verdict

All bad things aside, leverage is good. Leverage is actually great. But using it properly is a matter of finesse and know-how. So, here is my advice. Don’t jump into it head first! Take your time and learn the drill, experiment a bit with free trading software demos and see where that gets you.

And when you finally get to risk your own money, make sure you have risk management strategies put in place to protect you from any potential downfall. Other than that – Godspeed!

CFD Trading | What is Leverage?

Higher Leverage, More Trading Power

Traders worldwide use CFD because of its leverage feature. Leverage in CFD Trading is an investment strategy that allows them to gain exposure to the financial markets with a smaller upfront capital, know as margin. This allows them to make their capital work harder for them and achieve a higher return on equity.

Example of Leverage in CFD Trading

Shares of Stock A is currently quoting a price of $3.00 and Jasvind intends to buy 5,000 contracts of Stock A using CFD at the Ask price of $3.00. Assuming Phillip CFD sets the margin for Stock A at 10%, then the initial margin Jasvind puts up will be 10% x $3.00 x 5000 = $1,500 .

If Jasvind were to buy the same shares of company A using normal stocks on cash market, he would be required to put up $3.00 x 5000 = $15,000 .

In this situation, Jasvind has leveraged 10 times. This effectively frees up Jasvind’s capital for other investments such as Real Estate, Futures, FX trading, ETFs, Unit Trusts, Insurance, and so on.

However, trading on leverage is a double-edged sword, as it is possible to lose more than what you put into the investment, which is why prudent risk management practices and using the right trading platform for your trades is very critical.

Basics to CFD Trading

What is Leverage?

Important Notice

CFDs may not be suitable for customers whose investment objective is preservation of capital and/or whose risk tolerance is low. Customers are advised to understand the nature and risks involved in margin trading. Any CFD offered is not approved or endorsed by the issuer or originator of the underlying security and that the issuer or originator is not privy to the CFD contract. Phillip Securities Pte Ltd reserves the right to amend the published information without prior notice. You are advised to read carefully and understand the Risk Disclosure Statement before undertaking transactions in CFDs. As CFD is a Specified Investment Product (SIP), retail customers are subject to the relevant assessment for trading/investing in SIPs. This advertisement has not been reviewed by the Monetary Authority of Singapore.

Copyright © 2020. Brought to you by Phillip Securities Pte Ltd (A member of PhillipCapital) Co. Reg. No. 197501035Z. All Rights Reserved.

The following are all the terms & conditions that you must read, understand and agree to when trading CFDs with us.

What Is CFD Leverage?

Unlike traditional dealing, CFD trading enables you to trade the markets by paying just a small fraction of the total trade value.

CFD Trading Leverage Example: Barclays

In conventional dealing, you would have to pay your broker the total value of the shares you wish to purchase. Say you wished to purchase 10,000 Barclays shares and the current value of its shares is 160p. You would have to pay the total value of the shares purchased, i.e. £16,000 (10,000 x 160p).

With CFD trading, however, you only have to deposit a small percentage of the total trade value whilst maintaining the same level of exposure. If we charge our margin rate for Barclays of 15% of the total trade value, you would need to only deposit an initial £2,400 (10,000 x 160p x 15%) plus commission to trade the same £16,000 exposure.

Our typical share margins range from 4% to 25% on our most popular shares whilst our margins for Indices CFDs such as the UK 100 and Wall Street start at just 0.5%. Our margins for major currency CFDs and commodity CFDs start from just 1%. Please be aware that some CFD contracts incur a small overnight financing charge. Find out more about our financing and charges.

Example of gains

By only having to deposit a small fraction of the total trade value whilst maintaining a full exposure, you can magnify your gains. In the above leverage example, you only need to make an initial deposit of £2,400 plus commission whilst maintaining a total exposure of £16,000. Were Barclays’ share price to rally 10% in your favour, you would net a profit of £1,600. This represents a return on investment of 67% even though the share price has only moved 10%.

Magnifying your losses

As with all forms of financial trading, there is the potential to lose all or part of your investment. The key risk with leverage is that it can magnify your losses in exactly the same way as your gains. If the Barclays share price had moved against you falling to a new price of 144p, your position would now be worth £14,400 resulting in a £1600 net loss. This represents a return on investment of -67% as the share price has dropped 10%. Your City Index CFD trading account includes a range of risk management tools to help you manage your risk. Find out more about CFD trading risks.

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