Do CFDs provide leverage?
The contract for difference has a built-in leverage feature that differs from broker to broker and asset to asset. Leverage increases both trading profits and trading losses, allowing the market participant to gain exposure with borrowed capital. Current European Union regulations limit leverage on major currency pairs to 30:1 and minor currency pairs to 20:1. Additionally, these rules provide negative balance protection so that the trading account never drops below zero.
Forex contracts for difference are bought or sold in standard, mini or micro “lots”, or unit sizes, which correspond to $100,000, $10,000 or $1,000 of the underlying currency pair respectively. So, for example, a broker following EU rules will allow the trader to buy three mini-lots of EUR/USD CFDs ($30,000) while depositing collateral (free account capital) of only $1,000 .
It is important to understand how leverage will positively and negatively impact your trading returns. For example, if you buy $30,000 of EUR/USD using 30:1 leverage on a $1,000 account, all you need is a move of 3.33% ($30,000 * 0 .0333) to double your money or wipe out your capital. So while leverage is an attractive tool, it’s also a double-edged sword.
To use leverage, the trader must open a “margin” account as opposed to a “cash” account. Each broker has different criteria for opening a margin account, but most require a higher minimum stake than a cash account. Additionally, the candidate may need to answer questions about their trading experience and investment knowledge.
After opening a margin account, the trader must maintain a specific amount of capital. Each position requires the account holder to deposit a specific amount of funds from this pool of capital, called “initial margin”. This is the money needed to cover the loss if the transaction does not go as planned.
The broker will ensure that the account holder has funds to cover potential losses or positions will be closed automatically to cover the shortfall. As the market moves, the amount of margin needed to hold the trade will change. If the value of the position decreases, the broker will take a “maintenance margin” to cover the losses in addition to the initial margin. If the value of the position increases, the initial margin will remain unchanged, but the maintenance margin will decrease.
The margin calculation is real-time, telling the broker the minimum amount of capital required for the account holder to maintain the trade. If the position moves against the trader and the account capital is not increased, the broker has the right to liquidate the position. It is essential that new traders understand the written margin agreement and the rights of the broker to liquidate positions before they start trading CFDs.
Manage your risk
CFD trading can be risky, especially if using leverage, so a written trading plan (trading rules) must be in place before entering a position (see ‘Psychology and Trading’). Limit the amount of individual trade exposure to a small percentage of total account size, providing a measure of safety as your trading skills develop. Place stops on all trades, cut your losses, and if the market moves in your favor, adjust the stop and lock in some profits.
Contracts for difference (CFDs) are financial derivatives that allow market participants to trade in the foreign exchange market without buying or selling currency pairs. CFD pricing tracks the underlying assets and provides leverage to enhance returns. Trading CFDs requires opening a margin account with a CFD broker. Leverage can significantly improve forex trading returns, but will also generate damaging losses, especially when applied incorrectly. A well-designed risk management plan is necessary to trade CFDs for consistent profits.