Published On: Wed, Oct 31st, 2012

The Principle of Leverage as it Applies to CFDs

Leverage can both be the doing and the undoing of any great trader. This single facet of CFD trading can either make or break a trader’s career. For the most part, most millionaire traders have made their millions because of leverage. Without this vital aspect of Contracts For Difference trading they would most likely still have been toiling to build up their trading capital – which can take many years of trial and error.

Indeed, most of today’s most popular trading forms, including spread betting and CFD trading, heavily rely on leverage for its success. This ability to benefit way beyond the level of their available capital attracts tens of thousands of aspiring traders every year. But what precisely is leverage, how does it function and what role can it play in making a trader more successful?

What it essentially boils down to is that leverage is loan finance provided by the broker to allow the trader to ‘gear up’ his market exposure while only having to invest a fraction of the amount he or she is actually trading with. The broker thus allows the trader to open a trading position that is significantly higher than the funds in his or her trading account. It is not unlikely for brokers to offer 20:1 leverage on CFD accounts, which means the trader only has to have access to $5 000 to control assets (shares, commodities, currencies) to the value of $100 000.

However, while leverage could dramatically affect the positive outcome of any given trade, it nevertheless also represents a major risk and danger – especially in the case of inexperienced traders who do not understand its pitfalls. The higher the leverage, the more money the trader can potentially make with any given amount of trading capital, but the smaller the adverse market movement that is required to completely wipe out the trader’s account.

Diversification and leverage: While most stock traders would under normal circumstances understand the dangers of risking all their trading funds on a single stock, many of the same traders would gladly do so when they arrive in the world of CFD trading. This is a huge mistake which is especially important to avoid when one is dealing with leveraged trading products.

One of the best ways to avoid unnecessary risk in a leveraged account is to diversify the portfolio as much as possible. Never risk 100% of a given trading account on a single CFD trade. Having at least 10 CFD trades in the same portfolio would eliminate much of the risk.

Stop Losses and leverage: Most stock traders are familiar with the use of stop losses to minimise loss in case of an adverse price movement. One can’t, however, simply transfer a successful stop loss system from stock trading to CFD trading – the leverage aspect of CFD trading requires a different approach.

Where a 10% stop loss ratio in stock trading is not uncommon, using this approach in a 10% leveraged CFD trade would effectively mean that the trader would wait until his or her total account is wiped out before exciting the trade. The correct stop loss to use with such a trade would be 10% of the un-leveraged stop loss, i.e. 10% x 10% = 1%. If the price of the underlying asset goes 1% in the ‘wrong’ direction, get out of the trade.

The exact amount depends on the trader’s risk appetite and on market volatility. While getting out of a bad trade early is imperative for long-term success, stop losses which are set too tight cause more traders to lose money than probably any other aspect of CFD trading.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.