How to Trade CFD’s with the Right Leverage?

There are pros and cons to trading CFDs and most of the arguments for trading these products surround the concept of trading using leverage. Leverage makes trading of CFDs more efficient than other types of trading. So, what is the correct way to leverage your position?
How to Trade CFD's with the Right leverage?

The capital markets represent an excellent arena for investors to trade securities. Robust volatility provides the backdrop to make money by speculating that the price of a security will rise or fall. One of the issues investors face is that to make money you need to have money.  Historically, if you wanted to participate in share trading of equities or equity indices you needed to have enough capital to purchase shares. Fortunately, there are now products that allow you to speculate on the direction of a security without purchasing or short-selling that security, known as contracts for differences (CFD’s).

What is a Contract for Differences?

A contract for differences (CFD) is an agreement between two parties that provides access to the risk of an underlying instrument. The CFD will pay the difference in the price between where the contract was purchased and where it was sold. There is no physical exchange for the underlying product. So, if you purchase a CFD on crude oil you do not have to accept delivery of the crude oil. It is solely a financial instrument that pays the difference in price.  So, all you are really trading is the profit and loss based on the movements of an underlying instrument.

Stock shares, indices, commodities, as well as currencies can be traded using contract for differences. These instruments are cost effective and that is one reason they are very popular. Some of the most popular CFDs including Wall Street Indices, German Indices, along with commodities such as crude oil and gold. It is important to find a reliable broker to trade CFD’s.

Let’s compare the process of trading a contract for difference relative to the purchase of shares of a stock like Facebook. If you purchase shares, prior to execution you would need to have the amount of capital in your account to buy the shares. At approximately $180 per share, 10-shares of Facebook would cost $1,800 dollars. U.S. laws only allow you to leverage your account once you have purchased shares. For example, once you buy these shares, your broker would allow you to borrow 50% of the value of the shares ($900 in this example), to purchase more shares. So, to purchase another 10-shares, you would only need to post another $900 instead of $1,800.

If you are trading a CFD on Facebook shares, your broker would only require a margin amount that would cover the potential change in the price of the stock. The calculation of your margin requirement would be based on an algorithm that basically attempts to define the maximum loss you might experience in one-day. For example, if a 3-standard deviation move in Facebook shares was $20 per share, then your broker would ask you to post $20 multiplied by the number of CFDs you own.

The calculation of your profit or loss on a CFD is very straightforward. All you need to do is subtract the price that you purchase the CFD from the price that you sold the CFD and multiply that by the of CFD you own.

What is Leverage?

There are pros and cons to trading CFDs and most of the arguments for trading these products surround the concept of trading using leverage. Leverage makes trading of CFDs more efficient than trading shares of stocks or indices, but it also increases the risks associated with your trading strategy.

By trading using leverage, you can increase your returns substantially. Leverage can range from 2-1 to 400 – 1. Leverage of 10-1 means that for every $10 you post in margin you control $100 in notional value. In our Facebook example, if you use margin that is 10-1, for every share of Facebook you would need to post $18. Since CFD trading is focused on the potential loss that you could experience, the amount of capital you need to have to generate robust returns is a lot smaller than the amount you would need if you were trading shares.

Leverage also allows you to maximize your returns. Here is an example of the difference in what you would make using a CFD on the S&P 500 relative to purchasing the index. At the current price of 2,700, you would need $2,700 to purchase 1 S&P 500 contract. If the index increased to 3,000, you would make 300 or 11% (3,000 – 2,7000) / 2,700.

If you employed leverage into your calculation the returns would be more significant. For example, if you employed leverage of 10 to 1, you would need to post $270 to purchase an index that is 2,700.  If you made $300 if the index moved to 3,000 from 2,700 you return would be 111% = ($300 / 270).

Leverage can help you generate significant returns, but there is also increased risk when using highly leveraged products. Using the same example, if the price of the S&P 500 declined from 2,700 to 2,400, you would lose 11% without leverage. If you used the leverage of 10 to 1, your loss would be more than the $270 you had in your account, wiping out your entire account!

In practice, prior to losing this amount, you would get a call from your broker, requesting that you immediately put up more capital. This is referred to as a margin call.  When you receive this notification, you only have a small window to increase your capital otherwise your broker will liquidate your position before you fall short of the minimum required in your account to hold on to your positions.

The Benefits and Risk of CFD’s

There are many pros and cons of trading CFDs. CFDs allow you to have access to products that you might never be able to trade especially if you have a small account. For example, if open a $500 account, and wanted to focus on trading Facebook shares, you would only be able to purchase 2-shares. When trading CFD, you might be able to employ leverage of 10 to 1, allowing you to theoretically have access to $5,000 in Facebook shares. Since you are only trading the difference between where you buy, and you sell, your broker can afford to provide leverage up to the point where you could theoretically lose $500 dollars.

Another benefit of CFDs relative to shares is the relative ease in which CFDs can be traded short. When you short shares or indices, you need to borrow the shares and plan to pay back the shares when the price moves lower. In many instances, the cost to borrow shares can be significant. The less liquid the shares the costlier it is to borrow those share for the purposes of short selling. A standard cost to borrow shares is 6% per annual.  So, if you borrowed $1,000 for a year and the price of the stock you are shorting did not move, you would lose $60 per share.

When you trade using CFDs you do not have to borrow shares, because the instrument has the capabilities on its own to provide you with a short position which speculates that the underlying instrument will move down in price. When you sell CFD, all you need is a buyer of that CFD to allow you to create a profit that is your entry price minus your exit price.

When you trade CFD shares you can place your order with a broker or use an online electronic exchange. Your broker acts as a dealer and will immediately place your order when you call. Most brokers will, in fact, take the counterparty risk, which means that in many instances you are also taking counterparty risk. While you might not believe this to be the case, you are taking the risk that your broker is able to pay you your profit when you withdraw your capital. This does not necessarily mean that the broker is trading against you, instead, it means that the broker will ensure that you get paid when you have a winning trade. If your broker is unable to collect margin at a sufficient rate, you expose yourself to credit risk.

Finding a Good and Reliable Broker

There are several good brokers that execute CFDs, but few that are completely neutral. Many take positions against you and therefore they have a rooting interest in the price moving against you. It’s important to find a 100% market neutral trader, that allows you to trade against the market and not your broker. You should also look for a broker that has a wide range of platform choices. This includes a downloadable platform such as MT4, as well as a web platform that will allow you to access your account wherever there is access to the internet. If you like to chart CFDs, make sure your platform has an excellent charting package. You also want to make sure that you can trade when you are on the go.  Finding a broker that also has a good mobile platform that will allow you to trade when you need to and not only when you are home or in your office. InterTrader is one of the most reliable and well-reputed brokers to offer CFD’s trading with a user-friendly trading platform and low commissions compared to competitors.

What is the Right Leverage to Trade CFD’s?

Using the right leverage is an important part of determining the trading strategy you want to employ. Too much leverage will increase the risks of ruin, while too little leverage will hinder your opportunity to generate the returns you are looking for.

You need to initially determine what type of trading strategy you want to use to generate returns. For example, if you are looking to scalp the market searching for small changes in the price of an asset, you will need significant leverage to create robust returns. On the other hand, if you are employing a trend following a strategy where you are looking for large moves that might take some time, you might need less leverage to generate the returns you are looking for.

You also need to analyze the underlying products that are used to create a CFD. For example, the movements in the forex markets are relatively tame compared to shares, commodities, and indices. Forex markets generally have relatively low historical volatility. To generate robust returns in the forex markets you need to increase the leverage you are using.  For shares or indices which have significant historical volatility, you should consider using lower levels of leverage.

Summary

Contracts for differences are a trading instrument that allows you to speculate on the direction of an asset. CFDs are different than trading the underlying asset as you are investing in the difference between where you purchase your CFD and where you sold it. So, as opposed to having to buy a security, you only have to post enough margin to allow you to cover a loss that outside the normal range of losses you could experience. The leverage employed when you trade CFDs allows you to generate excellent returns, but the risks are also significant which means you need to be careful when employing leverage. Prior to depositing money at a broker, you should look for one that is 100% neutral so you are trading against the market and not your broker.

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