The ABCs of CFD trading and the magic of the CFD leverage
The leverage is the main thing that attracts people towards CFD trading (Contract For Difference). Here is how it goes. In your everyday forex trading transactions, if you want to pay for an asset, you need to offer the full price. You want to purchase 1.000 shares at $3 each? Then you have to pay $3.000 for the lot.
Now, there are mainly 2 types of people that deal with classic trading options involving full buys: the rich ones and the rookies. Sure, there are pros that like to stick to that type of trading as well, but they are definitely the minority. Why? Well, I thought it was obvious. Because of the CFD trading and the leverage.
The leverage is the ability to use one asset’s full value without having to pay the asset’s full price for you to do that. So, if you want to control a $3.000 worth of an asset, all you have to do is to pay a fraction of that amount. Usually between 5% and 25% of the full price. And you borrow the rest from your broker.
Why is this fact important? Because, by doing so, your gains will be defined by the full value of the asset you are controlling, not by what you have literally invested. What this means is that you get to invest, say, 10% ($300) and your gains will be multiplied based on the asset’s real price of $3.000, instead of taking your 10% investment as a point of reference.
I don’t think I need to explain how much money you can make off of that simple system, do I? I have been trading using leverage-based strategies for a lot of time now and I have had my ups and downs, I have to admit it. But, after being in the business for so long, I came to understand just how effective and productive this mechanism is.
Here is what I mean by that:
– You get access to otherwise inaccessible markets – Not everybody has the financial potency to risk thousands or tens of thousands of dollars on high-value markets, where usually the big sharks played. Leverage changed that, by the simple fact that you can control an expensive asset or security by only paying a percentage of its real value.
This translates by opportunity. The opportunity to operate on the same markets as the big boys and juggle with the same money they do. This, in my opinion, is one of the most seductive aspects of leverage altogether.
– The winnings multiply considerably – Since you get to control high value assets, your gains will grow depending on the asset’s real value, not what you have actually invested. This is the aspect that attracts most of the people in the CFD trading.
– Lower risk of losing your money – Think of it this way. Say you need to control a $20.000 position in the forex trading. What you need to do is to actually invest $20.000 and buy that position, right? Now, what happens if your bet fails? You lose $20.000 in one go. Nothing you can do.
With the leverage being used, if you want to control a $20.000 position, you only need to invest a percentage of the sum. Say 10%, which is $2.000. If your position fails and you close out in time, you can actually minimize the loss by a lot. You will only risk $2.000 instead of $20.000.
You don’t have to be a math genius to see the advantages.
– Raises interesting opportunities – Let’s say you have a tip regarding a major trade between two corporate giants that is bound to send ripples throughout the entire economic and financial sphere. What do you do? I bet you would be interested in acquiring some shares, right? But the problem is that the shares have already begun growing and your capital is too low.
One word – leverage. You use leverage to access a higher capital and buy as many shares as you can, thus allowing you to take advantage of an opportunity that would otherwise be inaccessible. And, trust me, it happens a lot.
This is what I personally love about CFD trading. Now, since we are here, I want to expand on some aspects. Leverage works by acquiring a margin. A lot of people are confused about the difference between the two, so I would like to clarify that aspect here, before going any further.
The margin represents the amount of money you borrow from your broker. The debt itself. The leverage is the act itself of borrowing and getting capital increase by using the margin. Think of it this way. The margin is the lever you pull and the leverage is the effect that follows.
With that out of the way, let’s focus on the least pleasant aspect of resorting to leverage trading.
How does leverage work in CFD and are there any downsides?
You will never hear about the risks of CFD leverage trading and for good reasons. He is interested in keeping you active for as much as he can, because an active trader is a profitable trader, regardless if he wins or loses. There are very few brokers that will actually break it down to you fair and square.
Which is why I am here. Call me the Voice of Reason, but I think that, as a broker, lying or hiding information from your potential clients will only help build an unflattering reputation.
So, here is what you need to know about CFD trading leverage that you don’t hear too often:
1. Capital multiplication can work against you
People tend to forget that leverage is potentially rewarding and damaging at the same time. If you get pumped at the idea of multiplying your potential gains by a factor of 10, you will surely deflate in an instant at the idea of multiplying your losses by an equal amount.
This is the nasty side of any leverage trade and it eventually bites on all traders who tend to disregard the danger and take the mechanism for granted. The notion of capital multiplication can be both seductive and scary and this is one golden rule you need to take with you each time the trading market calls.
2. It is an unreliable when the asset is extremely volatile
The risk of leverage slapping you over the face is multiplied when the asset is extremely volatile and unpredictable. Because, if you can’t determine its movement pattern or trend, the risk of losing your capital will become extremely high.
And, with leverage, you will end up even losing capital you don’t have, because of how the win-loss multiplying mechanism works.
3. The risk of losing sight of the market’s movements
With leverage, you need to be almost constantly wired to the trading market and take immediate actions when you notice that the things start going downhill. Cutting the losses is one of the main CFD trading strategies and you won’t be able to pull that off if you are not connected to the matrix nearly around the clock.
Once you have lost sight of the market, the consequences might hit you like a sledgehammer, crashing your world around you. Because, remember, with leverage, the losses could gain epic proportions quick.
Is there a way to use a safety harness?
Reader, meet Leverage Risk Management. From now on, this little guy will be your best friend. Treat him well and listen to what he has to say, because he is one smart little fella. Risk management, when dealing with leverage, is absolutely imperative. It is imperative in trading in general, I will give it that, but it is that much more important in this particular situation, when things can go haywire in the blink of an eye.
In order to prevent those unpleasant possibilities, there are certain security measures you can resort to:
1. Feel the market, become the market
I have to say, this is my personal favorite. Keeping the market under strict surveillance and analyzing trends, patterns, news and tendencies is what will get you out of a lot of problems. Prevent instead of treating, because treatments are usually more expensive and overall riskier.
And with CFD trading you need to double down on that market analysis as often as you can. When it comes to the trading business, most of the surprises are bad surprises.
2. Only get safe assets
By safe assets I mean those that are overall steadier and don’t tend to swing from one extreme to another too often. In other words, look for assets or securities with a low volatility factor.
If you are going to ignore my advice and aim for the more volatile ones, at least make sure you can predict the direction the asset will head.
3. Use stop-losses orders
This will help you exert a higher degree of control over the losses whenever the value of a certain asset goes into the wrong direction. It is a safety measure you can add to your margin account and you can and should activate it before taking on any serious engagements.
4. Don’t go multi-bidding
The more experienced traders will resort to leverage multi-bidding, placing bids for several assets at the same time. In and of itself, this bidding method isn’t necessarily bad. It gives way to a lot more profit over shorter periods of time.
But imagine what will happen if your bids fail. Imagine the financial hole you will find yourself in. It is smart to take one asset at a time, especially when you are in your trading childhood and lack the proper knowledge and skills to control the outcome of a trade.
All bad things aside, leverage is good. Leverage is actually great. But using it properly is a matter of finesse and know-how. So, here is my advice. Don’t jump into it head first! Take your time and learn the drill, experiment a bit with free trading software demos and see where that gets you.
And when you finally get to risk your own money, make sure you have risk management strategies put in place to protect you from any potential downfall. Other than that – Godspeed!