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The Workings of Leverage and Margin Trading

Posted By Robert On Sunday, January 26th, 2014 With 0 Comments

So let’s get right into CFDs here. We assume you have a general understanding of active investing or trading and are looking to CFDs as a means of ramping up your results.

In order to be successful requires a full understanding of the difference between margin and leverage and more importantly how to manage leverage as it’s a double edged sword.

Many people (and some tip sheets) falsely suggest that you should use $500 margin in each trade. This doesn’t take into account your float size, the margin required by the CFD provider, the risk on the trade (it can be more than $500) or your total exposure when taking into account other positions that you hold.

Let’s go over the basics so you fully understand and can always trade with your own best interests in mind.

Margin is the amount of money required to hold a CFD position e.g.

What is Margin?

The margin requirement will be taken from your account that you have with your CFD provider once the trade is taken. Margin requirements range from 1% – 50% and most traders focus on this factor much too heavily. CFD providers proudly promote their margin requirements being lower than everyone else‟s to get you in the door but this can become the downfall of new traders as they soon over leverage their account.

Position leverage is the number of times that the margin amounts are multiplied compared to the total position(s). In the above example we have $1,000 margin used to hold a $10,000 position so we have 10x leverage. A 1% increase in the value of our $10,000 ($100) position will equal a 10% increase in that of our investment of $1,000 ($100). This is the power of leverage.

What is Leverage?

With this one position your $5,000 account summary as you see in your software may now look like this:

Position Leverage

Many traders think ‘Great, I now have $4,000 left to take additional positions’ and this is where they get stuck because it doesn’t show the full picture.

Let’s assume the same ABC share CFD product you were buying had only a 1% margin requirement and you still purchased $10,000 worth:

Opening Positions on Margin

Your account summary would then look like this:

Margin Equity

The same trader could look at this and feel they are totally under-exposed and want to buy many more positions to take up the leverage on offer and free equity available in their account.

In both cases though the exposure is still $10,000 i.e. the position size you hold. The total exposure is rarely shown by CFD provider software as a total, but it is easy to work out when you know how and why.

Portfolio leverage is also expressed at a multiple but is more important as it takes into consideration your overall exposure i.e. the total size of positions you hold (total risk) compared to your total equity. With our example of a $10,000 share CFD exposure (using 10% margin) and our equity being $5,000 we have a portfolio leverage factor of 2x i.e. $10,000 exposure compared to $5,000 float.

Simple enough but let’s see what happens with multiple positions and different margins.

We will start with the first ABC example above of one position at 10% margin:

Equity Margin

Relevant numbers not obvious:

Position size/exposure would be $10,000

Position leverage would be 10x

Portfolio leverage is 2x

Let’s assume you now take a second trading position.

Share CFDs

Relevant numbers not obvious:

Position size/exposure would be $20,000

Portfolio leverage is 4x

And finally a third position. This time let’s buy an index CFD.

Index CFD

Relevant numbers not obvious:

Position size/exposure would be $44,000 (10k +10k+24k)

Portfolio leverage is 8.8x

Now our optimistic trader might still be thinking they still have $3,260 available to take on further positions. It must be realised that with 8.8x leverage, every 1% the market moves against you, you would lose 8.8% of the equity. An average 11.4% move against the total portfolio (at 8.8x leverage) would consume the entire trading float and worse, may see you owing additional money to your CFD provider after slippage/ brokerage etc. Some people may have a stop loss 10% away from the opening price so if all 3 positions are stopped out, your trading days are almost over in just 3 trades.

The more leverage you use the greater your returns can be but in the same way you will also increase your losses. To survive with any leveraged product, you need to use the available leverage wisely and to a maximum affordable point. You can leverage too highly into real estate or margin loan investments and likewise with CFDs so you need to think through your objectives, strategies, needs, risk tolerance and do the numbers to see what suits you.

One rough way to calculate it would be to take the maximum drawdown you would accept, divided by the typical stop loss range you utilise and use this to derive the maximum leverage that you can safely tolerate.

DrawDown

Each person will have different needs but newer traders should leverage more conservatively until they get sufficiently skilled. At this stage consider something like 3x portfolio leverage as being the maximum. Finally, when more experienced and with some profits in the kitty consider 5x portfolio as the absolute maximum. Some professional traders might look to 10x portfolio as an absolute maximum on occasion where they have some guaranteed stop losses and are actively watching the market.

In practice you will calculate the total equity you have (say $7,000) then multiply this by your maximum leverage factor (say 3) and this will give you the maximum portfolio value you can hold ($21,000). If you are buying new positions and you already have 2 valued at say $9,000 each, you would only consider adding an additional $3,000 position at most. The amount of margin that is used is really immaterial in terms of risk management.

Margin still has a place to play though in that your CFD provider will have certain requirements for you to have sufficient funds available and some margins are 50% so the maximum you can leverage up would be 2x. In practice though the products that most traders regularly use have a margin requirement that is much less than 50% so the next thing to check is the threshold at which you get margin calls to save you being stopped out by the provider.

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