Why calculating CFD leverage is utmost essential?

Oct 21, 2021CFD Trading0 comments

A contract for differences (CFD) is a financial contract or an arrangement that pays the settlement price differences between the opening and closing trades. They allow investors to trade the direction of securities over the very short-term and are highly famous in commodities and FX products.

Even though they are cash-settled, but they allow ample trading margin trading to the investors. CFDs offer traders all of the merits and risks associated with owning a security without actually owning it or having any asset’s physical delivery.

CFD leverage

Also, trading on margin CFDs generally offers higher leverage than traditional trading. Standard CFD leverage trading can be as low as a 2% margin requirement and increase to 20% margin. Lower margin requirements also mean lower capital outlay and higher potential returns for the trader.

Without further ado, let’s jump into the aspect of leverage CFD trading in details as follows:

Part 1: What is CFD leverage?

Traders worldwide use the CFD leverage feature as its powerful also. Financial leverage in CFD Trading is an investment strategy that helps traders gain exposure to the financial markets with a bit of upfront capital, also called margin. This margin trading strategy assists traders in making their capital work harder for them and grabbing higher equity returns.

Example of Leverage in CFD Trading

Let’s say the current opening price of Shares of Stock A is $3.00, and Jasvind wishes to purchase 5,000 Stock A contracts using CFD at the $3.00 Ask price. Assume that the Phillip CFD sets the margin at 10% for Stock A, then the initial margin will be 10% x $3.00 x 5000 = $1,500 by the Jasvind.

Also, he needs to put up $3.00 x 5000 = $15,000 if Jasvind were to buy the same company A shares using normal cash market stocks.

In this situation, the CFD trading leverage is ten times. It further releases Jasvind’s capital for other investments such as Futures, Real Estate, ETFs, FX Trading, Insurance, Unit Trusts, etc.

However, CFD leverage is a double-edged sword, as you can lose more than what you invest, which is why using the right trading platform and prudent risk management practices are very critical.

Part 2: What are the benefits of leverage CFD trading?

This approach to leverage CFD trading has grown in popularity over the past decade, specifically with some brokerage firms providing negative balance protection to limit heavy losses thus, putting your trading account into debt.

The CFD leverage ratio is as high as 100:1 in the foreign exchange markets. This means that for every $1,000 invested in your account, trading up to $100,000 in value can be done. Many traders believe these market brokers provide such high leverage because leverage is a risk’s one of the functions.

Now, understand some of the critical merits of leverage in CFD trading.

Investors use leverage to grab the high amounts of profit from forex trading. And, this market provides one of the most significant amounts of power available to investors.

In general, the CFD leverage is a kind of loan that a broker offers to an investor. The trader’s forex account assists margin trading or borrowed funds. As a result, some brokers may limit the CFD leverage amount used initially with new traders.

In most cases, traders can tailor or design the amount of trade’s size depending upon their desired leverage. First, the broker will need a percentage of the trade’s notional amount as cash, known as the initial margin in accounts.

Types of Leverage Ratios [CFD Leverage Ratio]

The initial margin needed by each broker can vary, depending on the size of the trade. For example, if an investor buys $100,000 worth of USD/EUR, they may need to place $1,000 as a margin in the account.

As a result, the margin requirement comes out as ($1,000 / $100,000) or 1%.

The leverage ratio CFD displays how much the trade size multiplies by the broker’s margin. Using the above-mentioned initial margin example, the leverage ratio for the trade equals ($100,000 / $1,000) or 100:1.

Thus, an investor can trade $100,000 in a particular currency pair for a $1,000 deposit.

Below are examples of the leverage ratios and the corresponding margin requirements.

Margin Requirement Leverage Ratio
2% 50:1
1% 100:1
.5% 200:1

As the table above depicts, the lower the margin requirement, the more leverage for a single trade.

However, a broker may need more significant requirements of margin based upon a specific traded currency. For instance, the British pound exchange rate versus the Japanese yen can be pretty volatile. Thus, it fluctuates, causing large rate swings.

A broker may want more money held as collateral (i.e., 5%) for more volatile currencies and volatile trading periods.

CFD leverage in the forex markets tends to be higher than the 2:1 leverage generally offered on equities and the 15:1 leverage offered in the futures market.

Although 100:1 CFD leverage trading may seem highly volatile, the risk can lower when you determine that currency prices usually modify themselves by less than 1% during intraday trading. If currencies vary as much as equities, brokers would not be able to offer much CFD leverage.

Important Note: Forex brokers have to manage their risk and, in doing so, may increase a trader’s margin requirement or reduce the CFD leverage ratio and, consequently, the size of the position.

Part 3: What are the risks of excessive leverage in CFD trading?

This is where the risk and profit factor comes in, as real leverage can significantly magnify your losses and profits at the same level. The greater the capital leverage you put or trade upon, the greater your ultimate risk will be. Note that this risk does not essentially sync with margin-based leverage. Although it can highly affect the trader, it is not applicable.

Let’s understand this scenario with an example.

Both Trader A and Trader B trade with a capital of US$10,000, with a platform broker that keeps a 1% margin deposit. After analyzing, both agree that USD/JPY is hitting a top and should fall in value. Therefore, both short the USD/JPY at 120.

Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on their $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of their total trading capital.

Trader B is a more careful trader and decides to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on their $10,000 trading capital. That $50,000 worth of USD/JPY equals just one-half of one standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, equivalent to $415. This single loss represents 4.15% of their total trading capital.

This table displays the different trading accounts of these two traders compared after the 100-pip loss.

Trader A Trader B
Trading Capital $10,000 $10,000
Real Leverage Used 50 times 5 times
Total Value of Transaction $500,000 $50,000
In the Case of a 100-Pip Loss -$4,150 -$415
% Loss of Trading Capital 41.5% 4.15%
% of Trading Capital Remaining 58.5% 95.8%

Conclusion

All in all, you must not be afraid of CFD’s leverage once you have learned its management. The only scenario you should not use the leverage CFD trading is when taking a hands-off approach to your trades.

Otherwise, leverage is successfully used and profitably with proper management. Like any sharp instrument, leverage is a caring aspect to handle— and there’s no question to trading CFD without leverage.

More diminutive and real CFD leverage amounts applicable to each trade affords more breathing room by placing a more complete but reasonable stop and avoiding a higher capital loss. So, keep in mind that CFD trading leverage is entirely flexible, and you can personalize it as per the trader’s needs and preferences.

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