HomeTradingUnderstanding Leverage In CFD Trading: A Beginner's Guide

Understanding Leverage In CFD Trading: A Beginner’s Guide

Assume you’re at a garage sale and spot a bike you want for USD$100. Unfortunately, you only have USD$20 in your pocket. CFD trading leverage works like borrowing money from a friend to buy a bike.

Here’s how?

Let’s say your broker offers a leverage of 10x. This means for every USD$1 you put down, your broker lends you USD$9 extra. So, with just your USD$20, you can control a trade size of USD$20 x 10 = USD$200.

That means you could buy the bike and potentially even other cool stuff from the garage sale. This is exciting because leverage allows you to make bigger trades with a smaller amount of money.

Benefits Of Leverage

Leverage offers some advantages:

1. Bigger Trades, Bigger Wins

Remember how you could buy more than just the bike with leverage? That’s because leverage lets you control a larger position size with a smaller amount of money. If the market goes your way, you can potentially make much bigger profits than you could have without leverage.

2. Less Cash Upfront

Let’s say you only have USD$100, but you see an opportunity in the market that requires a USD$1,000 position. With leverage, you might only need to put down a fraction of the total cost (called the margin) to open the position. This frees up more of your cash for other trades.

3. Spreading Your Bets (carefully)

Leverage can also help you diversify your portfolio by letting you control positions in multiple assets with less money upfront. This can help spread out your risk, which is a fancy way of saying it protects you from losing everything on one bad trade.

But remember, leverage is a double-edged sword. While it can magnify your wins, it can also magnify your losses. That’s why you should know the ins and outs before trading CFDs.

Risks Of Leverage

We talked about how leverage can be like borrowing money to buy a bike at a garage sale. While it can be helpful, there are also some risks to consider:

1. Bigger Trades, Bigger Losses

Remember how leverage can magnify your wins? Well, guess what? It can also magnify your losses. Even small price movements against you can wipe out your entire investment.

2. Margin Calls

Imagine your friend (the broker) calls you up and says, “Hey, the value of the bike went down, and I need some money back!” That’s a margin call. If your account value falls below a certain level because of losses, your broker might force you to add more money or close your position to cover your risk.

3. Forced Liquidation

If you can’t meet a margin call, your broker might sell your positions automatically, often at a bad price, to get their money back. This can leave you with even bigger losses than if you had just closed the position yourself.

Using Leverage Responsibly

Here are some golden rules to remember:

1. Don’t Go Crazy

Use a leverage amount that you’re comfortable with. Only risk what you can afford to lose.

2. Keep an Eye on Your Margin

Remember how your friend (the broker) might call for more money if the value of the bike goes down? Keep your account funded well enough to avoid this by monitoring your margin levels and adding more money if needed.

3. Don’t Put All Your Eggs in One Basket

Spread your trades out over different assets. This way, if one goes bad, it won’t wipe you out completely.

Always be careful and make sure you understand the risks before using leverage in your CFD trading.

Understanding Margin Requirements

There are different margin levels to remember:

1. Initial Margin

This is the down payment you need to open a trade with leverage.

2. Maintenance Margin

This is the minimum amount of money you need to keep in your account to hold onto your trade. It’s lower than the initial margin.

3. Margin Call level

This is the danger zone. If your account value falls below this level, you’ll get a margin call.

Calculating Leverage

Not sure how much leverage you can use? Here’s a quick guide:

1. Know Your Risk Tolerance

How much are you willing to lose?

2. Check Your Broker’s Limits

Different brokers offer different leverage amounts. Choose one that fits your strategy.

3. Calculate Position Size

Divide your risk amount by the margin requirement to get your maximum position size. Remember, bigger positions mean bigger potential wins (and losses).

4. Factor in Leverage

Multiply your position size by the leverage ratio to see how much you could win or lose.

5. Account Math

Make sure you have enough money in your account to cover the margin and any fees.

6. Fine-tune Your Trades

Consider how volatile each asset is, how they’re connected (correlated), and how diversified your portfolio is. This helps manage risk and potentially boost returns.

Wrapping Up

So, there you have it. The 101s of leverage in CFD trading. You know that if you get it right, you’ll reap great dividends. But if you’re not careful, you may end up staring at the wrong end of some serious losses. Learn to strike a balance and you may just trade profitably while controlling your risk.

Ajeet Sharma, the founder of Financegab and a well-known name in the field of financial blogging. Blogging since 2017, he has the expertise and excellent knowledge about personal finance. Financegab is all about personal finance which aims to create awareness among people about personal finance and help them to make smart, well-informed financial decisions.


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