What is Leverage and what are Margin Requirements?

One of the main advantages of CFD trading is the ability to leverage or gear your position to gain greater exposure to the markets with the minimal amount of capital required. Leverage or gearing is very similar to  borrowing. It allows traders to increase potential returns by allowing you to increase your exposure by only contributing a fraction of the full notional value of the position.

The initial outlay the trader has to make to secure the position is referred to as margin. Whilst margining is a relatively basic concept we will cover Margin and variation margins in more depth in later posts with worked examples.

For many, the biggest appeal of CFDs is leverage and the big profits that it can facilitate. As the word spreads about the supposed overnight riches that are available, so does the increase of interest in the CFD market. Although leverage can be a highly beneficial feature of trading, it can also single handedly destroy lives with the losses it can bring

Anyone that is new to CFD trading needs to understand how leverage works – not only the risks involved but also the charges that need to be accounted for when employing the facility.  This article aims to highlight these

What is Leverage and what are Margin Requirements?

We have touched on these topics in previous guides but there is no harm in briefly going over the subject again.  When you open a position with a CFD broker, you are only required to have a small percentage of the contract’s value in your account.  For this reason it is possible to take out positions that are worth considerably more than your available funds. This can result in large gains and substantial losses, depending upon how you have designed the trade.

The percentage of the contract value that is required is known as the margin requirement.  Although it can vary from broker to broker and depending upon the market you are trading on, you will rarely have to have more than 30% of the trade’s value in your account to open it.

When trading on margin, it is strongly recommended that the individual is sensible when deciding upon the size of the trades.  If they over commit and the market goes against them slightly, the trader will often find themselves being stopped out by the CFD broker.  On the other hand, if they trade smaller amounts, it will allow them more leeway if their trade goes unexpectedly against them.

An example of leverage in action:

Chris Davies wants to buy 5000 shares in Tree Top Ltd – a company that is currently trading at 500-502.  If she were to buy these shares on the stock market, they would set her back a cool £25,100.

Rather than purchasing these shares the old fashioned way, Chris decides to buy them through a CFD with a company that has a margin requirement of just 5%.  In this instance, Chris is only required to have £1255 in her account to get the contract open.

Note:  She would be advised to have a buffer in place as any price movement against her could quickly wipe out her funds.

How Much Leverage do CFD Brokers Offer?

Margin requirements will vary between brokers and also between markets. The more liquid the market, the more leverage the broker will likely offer.  The same tends to go for markets that are perceived to be less risky.  For instance, the required margin will normally be less with a FTSE 100 trade than with an AIM stock.

Generally speaking, in Australia, Equity CFDs have margins ranging from 3% – 100%. Index and Indices products from 0.5% and Foreign exchange CFDs from 0.25%. As you can see great exposure can be gained from very little capital outlay.

Leverage then also enables traders to diversify a portfolio for risk mitigation purposes. Now that the trader has only used a portion of the funds they would have with an unleveraged version of the product they can take remaining funds and invest elsewhere in the market to diversify their portfolio.

Alternatively for those who simply do not have the initial capital to invest in the unleveraged version of the instrument a CFD is a great way to gain exposure without a great deal of capital.

Being so highly leveraged, CFDs require an adjustment to trading style. A risk management is imperative for successful trading.

A good example of leverage can be demonstrated in the example below. Here we can see the CFD trader and the Equity/Share trader invest in the same stock at the same price of $10 and for the same volume of 1000. The major difference here is that the CFD trader only outlays 5% of the full notional value of the position unlike the share trader who has to come up with the full value to enter the position. If in this instance both traders only had $10,100 to invest. Then the Share trader would be left with $85.05 to continue trading. On the other hand the CFD trader would still have $9,590 to continue trading. Thus truly illustrating the benefits of leverage and CFDs.