The Use Of Leverage in CFD Trading: How This Affects You CFD Trading Results

Leverage is one of the several reasons why CFDs are traded by traders who have previously traded shares.

Typically the margin needed with many CFD brokers is 5-10%. And different CFD brokers will give different amounts of leverage.

So what does 10% leverage mean? It means that with a $10 000 float, positions totalling $100 to 200 000 is possible if full leverage is used, in comparison to stocks and shares where there is usually no leverage, or with a margin loan there may be around 50% leverage.

In contrast, forex trading offers even more leverage at 100 to 1.

Why Some Trade CFDs Without Leverage Rather Than Shares

However some traders choose to trade CFDs rather than shares, but don’t use the leverage available. They open a trading account and never go above a 1 to 1 leverage.

So why do traders use CFDs instead of stocks in this case?

Well, some traders for example want to go short on shares, but this may be over $100 in commission one way with a traditional full service broker. With a CFD provider, the cost may be say 0.1-0.2% of trade size, which for a $10 000 trade is only $10-20 one way. Also interest is paid on short positions and this will reduce the costs of trading CFDs even further and in some cases completely offset the brokerage costs.

The other main advantage is that there are many more shortable stocks with a CFD provider than a stock broker. So if there’s a stock you want to short but can’t do so with the traditional stock exchange, then cfds will allow you to do so.

What's The Effect of Leverage in CFD Trading?

The use of leverage results means that your trading results are magnified.

This means that if your system has a profit of around 20% per annum and a drawdown of 7% on the cash float with zero leverage, then with 10 to 1 leverage the returns on that system will be 200% per annum and have a drawdown of 70% of cash float.

The effect of your whole system is magnified so it’s as if you’re trading with say $100 000 instead of $10 000.

Leverage also means that it’s important to have a profitable trading system, because this is what you’re magnifying.

The worst case scenario with leverage is that you can lose more than your original cash float. This can happen if you have for example, a lack of money management rules in your trading or you’re not using stop losses, or the stock falls to zero or to almost zero because of some event.

For example, say your cash float was $2000, and you’ve bought 200 CFDs at a market price of $20. In this situation, you have $4000 worth of CFDs. For this trade you’ve only used $400 of margin assuming a margin requirement of 10%. If say you don’t have a stop loss, and the price of the stock falls to $10, then your loss is $2000, which is all of your float. If the stock CFD price falls to zero, then your loss is $4000 which is double your cash float.

If you have good risk management and also sensible stop losses in place, then you’re taking action to avoid these situations.

I heard the other day that in some countries, less than 7% of traders use stop losses.

So leverage should be used wisely in CFD trading.