CFD leverage and margin

Leverage is a key feature of trading Contracts for Difference (CFD) – it allows you to open positions by paying only a fraction of their full value, known as your margin. Let's take a closer look at how leverage works in CFD trading.

1. What is leverage in CFD trading?

2. How does leverage work in CFD?

3. What is CFD margin?

4. Margin Calculation

5. Cost of leverage in CFD

6. How to manage CFD risks

What is leverage in CFD trading?

Leverage in CFD trading allows you to trade larger positions than you could afford by paying the full value of the underlying assets. Instead, you pay only a fraction of the position's value, known as the margin, which acts as a deposit required to open the trade.

Leverage can significantly increase your potential profits, but it also amplifies the risk of losses. Before you decide to trade on margin, it's important to understand how leverage works and to know how to manage your risks, for example, through the use of stop-loss orders.

How leverage works in CFD

Leverage in CFD trading works by allowing you to trade based on speculation about price movements, rather than owning the actual asset. This means that you don’t need to pay the full value of the asset you're trading, but only a certain amount as margin, which allows you to open a larger position.

For example, if you want to trade 10 contracts on the S&P 500 index when the price is at 4500 points, the total value of your position will be (10 * 4500) = 45,000 USD. However, to open the trade, you will only need to pay the margin, not the total value.

Even though you’re only paying the margin, your profit or loss will be calculated based on the full value of the position. For each point the S&P 500 index moves up, you will earn 10 USD, and for each point it moves down, you will lose 10 USD.

Advantages of leverage

Trading with leverage allows you to gain the same market exposure with a lower initial investment. This means that you don’t have to pay the full value of the trade to open a position, but only a small fraction, leaving you with more funds for other investments.

In our example, when trading a position worth 45,000 USD, you would only need to pay 5% of this value, which is 2,250 USD, freeing up the remaining 42,750 USD for other purposes.

Leverage can help increase your returns if the market moves in the direction you anticipated. This means that even a small market movement can significantly impact your profits. On the other hand, if the market moves against you, leverage will also amplify your losses. Therefore, it is crucial to manage risk effectively to avoid losses that could jeopardize your capital.

Example of CFD usage: Stock trading vs CFD trading

To better understand how leveraged CFDs work in practice, let’s look at a specific example.

Let’s assume you want to trade 1000 shares of XYZ company, which has a current share price of 25 USD. You can either directly invest in XYZ shares through a broker or you can buy 100 CFDs on XYZ shares.

In both cases, the total value of your position will be the same: (25 * 100) = 2,500 USD.

The margin requirement for trading XYZ shares is 30%. This means that when trading CFDs, you only need to pay 750 USD to open this position, instead of the full amount of 2,500 USD.

Leveraged trading allows you to utilize this margin, freeing up additional funds that you can use for other trades.

How leverage increases profits

When the price of XYZ shares rises to 26 USD following strong earnings, you decide to close your trade.

In both cases — with a traditional broker or with CFD trading — you would make a profit of (26-25 * 1000) = 1,000 USD. However, the return on investment for your CFD trade would be much higher.

Why? Because you only used 750 USD to open the position with CFD. This means the return on investment would be 13.3%, while with traditional trading, where you would have to invest the full 2,500 USD, the return would be only 4%.

How leverage increases losses

This is how leverage works when you make a profit — the same principle applies if you end up with a loss.

Let’s say your trade with XYZ shares was unsuccessful, and you decide to close the position with a loss of 100 USD. In this case, the return on your investment when trading CFDs would be -13.3%, because you invested 750 USD and lost 100 USD.

On the other hand, with traditional stock trading, the return would only be -4%, as you invested the full amount of 2,500 USD and lost 100 USD.

Therefore, using leverage increased your losses, as the risk is magnified in the same way as profits.

What is CFD margin?

CFD margin is the amount you must have in your trading account in order to open a position on a contract for difference. It may also be referred to as the margin requirement or market margin factor.

Margin factors can vary between different markets and are usually expressed as percentages. This percentage will show you what portion of the total value of your position you need to pay as a deposit. Generally, the higher the margin requirement, the more volatile or less liquid the market is.

Margin call and closing levels

To keep your leveraged trade open, you must have sufficient funds in your account to cover the margin at all times – especially if your position is in a loss.

Imagine you have deposited the required $750 to buy CFD shares of XYZ. If the price of XYZ shares drops and your position reaches a loss of $50, your account will only have $700 left, which is insufficient to cover the margin requirement.

This situation is called a margin call, and it may lead to the closure or liquidation of your positions. On y4trade.com, positions are closed if the account balance falls below 100% of the required trading margin.

To avoid position liquidation, you should always ensure you have enough funds in your account to cover the maximum potential loss while you decide to keep your position open.

Margin calculation

To calculate the required margin for any position, you need to know its total size and the margin requirement. For example, if you want to buy 5 CFD UK 100 at 6800 and the margin factor for UK 100 is 15%:

• The total size of your position is (5 * 6800) = 34,000 GBP.

• 15% of 34,000 is 5,100 GBP.

• You need 5,100 GBP, converted to your base currency, in your account as margin.

However, you don't need to do this calculation manually – every time you open a position on the y4trade.com platform, you'll see the required margin displayed in the contract ticket.

Maintaining open positions

When you have multiple positions open simultaneously, monitoring your total margin requirements can become complex.

• If the indicator is above 200%, you have sufficient funds to maintain your open positions.

• If the indicator drops below 200%, you risk your position continuing to decline, and it may be automatically closed.

• If the indicator falls below 100%, you no longer have enough funds in your account to cover the total margin. If the indicator drops below 120%, a warning symbol will appear next to the indicator.

What to do if you're close to liquidation

If you're approaching liquidation, you have three potential options:

1. Close your position: Acknowledge the loss and reduce your total margin requirement.

2. Partially close your positions: Reduce the size of your positions to free up some of your capital on the account.

3. Add more funds to your account: You’ll need to cover the margin shortfall and may want to add additional funds to maintain any further potential losses.

Costs of trading with leverage

In addition to margin, there are other costs that you’ll need to cover when trading leveraged CFDs. The main one is overnight financing.

When you trade with leverage, your provider essentially lends you funds to cover the full size of your position. Overnight financing represents the cost of keeping this loan open for more than one trading day.

How to  manage CFD risks

1. Use Margin Wisely When sizing CFD positions, it's usually a good idea to be cautious instead of using all your available capital for margin. As mentioned earlier, failing to do so may quickly put you at risk of liquidation. Many traders limit their risk to only 1% or 2% of their total funds for each trade. This way, you can endure multiple losses without facing a margin call.

2. Use Stop Orders Stop orders automatically close a trade when it reaches a certain loss level, helping to limit your risk on that position. You can add stop orders through the ticket or to an existing trade. It's important to remember that the price at which your position closes may differ from the price at which you set the stop order if there's a market gap. Gaps can occur when the market experiences high volatility, or when markets reopen after being closed (e.g., after the weekend), meaning the closing price may differ from the set trigger price.

3. Use CFDs for Hedging Since CFDs allow you to short-sell and potentially profit from falling market prices, traders sometimes use them as a hedging tool to offset losses in their portfolios. For example, if you have a long-term portfolio but feel that your investments are at short-term risk, you can use CFDs to mitigate potential short-term losses by hedging your position. In this way, if the value of your portfolio falls, the profit from your CFD position will help offset these losses, allowing you to maintain your portfolio without significant reduction in its overall value.

In this way, if the value of your portfolio declines, the profit from the CFD will help offset these losses, allowing you to maintain your portfolio without experiencing a significant decrease in its overall value.