What Exactly Is A CFD?
CFD is the widely-used acronym for a ‘Contract for Difference’. As the name suggests, it represents a contract (with a broker) that enables you to speculate on whether the price of a given asset will fall or rise, over a set period of time.
As a financial instrument, CFDs are extremely popular in the retail trading sector, particularly so within the day trading community. Many brokers offer CFDs, with the best trading platforms offering a broad range of markets including stocks, indices, Forex and commodities, of which stock CFDs are the most prevalent.
CFDs are financial derivatives, so in this type of trading you do not gain ownership of the underlying asset, or receive any benefits from the assets during the trading period. Profit or loss is determined purely on your skill and judgment as a trader.
Some Useful CFD Terminology
The following section is not directly related to using leverage in CFD trading, it is more about other CFD trading jargon you need to understand before you even think of applying leverage to a trading position.
If you are already a seasoned trader, you may already be fully familiar with plenty of trading terminology, so please think of this section as a little refresher. However, if you are a complete beginner you are more than likely finding it all a little bit confusing and you might find our how to buy stocks for beginners guide helpful for some further clarification, if you’re looking for which CFD trading signal providers you should check out, we’ve also got you covered there.
Long and Short
In CFD trading you are basically speculating on the price movement of an asset compared to the current market price, rather than buying the asset. The terms ‘long’ and ‘short’ refer to the position you take in a trade, ‘going long’ indicates you think the price will rise and conversely, ‘going short’ means you have speculated that it will fall.
In CFD trading, there are always two prices quoted against the asset, which are used to calculate the spread:
The Bid (Sell) price which refers to the price point at which you can open a short position
The Offer (Buy) price which refers to the price point at which you can open a long position
You will always find that the Bid price is slightly lower than the Offer price and the difference between the two prices is the spread.
Unlike some forms of trading, CFDs do not have a fixed expiry period and remain open until you take action to close them. Therefore, if you opened a trade from a Bid position, you can close it by opening a trade from an Offer position for the same amount, or vice versa.
The majority of CFD trades are closed before the end of the day’s trading, which is 22.00 in your local time, to avoid incurring fees for overnight funding. This is particularly relevant if you have applied leverage to increase your position as this will add considerably to the cost.
What is Leverage in CFD Trading?
One of the main reasons given for selecting CFDs, rather than investing in the assets themselves, is the advantages gained by using leverage in CFD trading. CFD leverage explained in very simple terms allows you to enter a trade with a relatively small deposit but to take a much bigger trading position by borrowing money from your broker.
Using leverage does increase your risk exposure exponentially. It is absolutely vital for you to know how to use CFD leverage wisely and to assess the implications of using it for every trade you enter so that you can minimise potential losses and maximise profit.
Trading Margins and CFD Leverage Explained
As is often the case with financial products, there is sometimes confusion between related terminologies and here we are referring to leverage and margins.
CFD leverage, explained earlier in this guide, enables you to extend your trading position using a loan. To take advantage of that facility, you are required to deposit some of your own money as a deposit, which is known as the trading margin. Your total exposure compared to your margin is described as the ‘leverage ratio’.
CFD leverage explained using a simple example:
You invest £100 in a stock CFD in which the shares are valued at £1 each. The leverage ratio for that trade is quoted at 10:1 so you could extend your trading position to a maximum of £1000 and buy 1000 shares in total.
If you have predicted correctly and the stock rises in price to £1.30 per share, you will have made a £300 profit which is ten times more than you could have achieved with your original £100 alone. However, if you are wrong and the price falls by 30p per share, you will lose your original £100 investment and owe your broker a further £200.
Leverage in CFD Trading Strategies – Scalping
Without going too deeply into this strategy, scalping is complex and we do not recommend that you try it without an adequate level of knowledge. If you are not 100% sure about any aspect, then confine this type of trading to a simulation, until you are confident.
Using a scalping strategy is not for the faint-hearted or easily-distracted trader. The essence of scalping is executing fast trades with a narrow spread and using a high leverage ratio. As scalpers often use extremely high leverage, they can generate huge profits in a matter of minutes, but equally there is the chance of sustaining a big loss. Most successful scalpers are professional, full-time traders, who spend their working hours executing multiple small fast trades, requiring an extremely high attention span.
Leverage in CFD Trading Strategies – Day Trading
Many of you might have been led to believe that day trading is the same as scalping. However, whilst there are similarities there are also some big differences; the way leverage is employed being one of those.
As a day trader, you are reliant on technical analysis and charting to identify suitable trading opportunities. Your aim is to open multiple, high-profit positions that can be closed within a single day and to minimise your risk exposure using much lower leverage ratios. With positions open for several hours, you may see the market price rise and fall, perhaps giving you some heart-stopping moments along the way, but you should always sit tight rather than pre-empting what might happen and closing a trade too soon.
Leverage in CFD Trading Strategies – Swing Trading
Our third strategy type, swing trading, is far less manic and intense than scalping or day trading and uses lower leverage ratios. However, it is not necessarily less time-consuming, as swing traders rely a great deal on analysing both technical and fundamental data.
The length of your trades could vary from a single day to a whole month, so using this trading strategy relies on having multiple positions open. You will need to assess every trade individually in order to apply a leverage ratio in accordance with your risk exposure and monitor the market closely for unexpected changes that could require action.
Capping of Leverage in CFD Trading
Using a high leverage ratio may seem like the ideal scenario, allowing you to make a large investment, which only requires a small fraction of your own money and has the potential to amass you a huge profit. However, always remember that there is the downside to consider, the one where you not only lose your own investment, but end up owing a small fortune to your broker as well.
Many traders have lost vast sums of money in the past by overusing leverage, sometimes encouraged by unscrupulous brokers, which is one of the reasons that CFDs came under the close scrutiny of various financial regulators across the world.
In some countries like the USA, brokers are now completely banned from offering CFDs to retail clients. However, most other regulators have opted to enforce a leverage capping policy instead, rather than a blanket ban. In the UK and Europe, the maximum leverage permitted for retail traders is 30:1 for CFDs.
CFD Leverage Explained – Do You Have A Plan?
Knowledge is power, so the old saying goes and it is certainly true if you are involved in any type of trading. Any time you spend reading, researching, analysing or practising is not wasted; to do well in the CFD marketplace is no easy task and you need to explore it from every possible angle.
One thing we always recommend to potential CFD traders is to start by creating a trading plan, irrespective of whether you are a complete beginner, someone seeking the best dividend stocks UK, or an experienced trader looking to extend your portfolio into the CFD marketplace.
The easiest way to start is with this simple list of questions:
- What is your motivation for becoming a trader?
- Do you have specific goals?
- How much time can you commit to trading?
- Which markets/assets interest you the most?
- How much capital or disposable income do you have?
- Have you considered the risks of trading as well as the benefits?
- Are you able to keep accurate records?
The list is far from exhaustive, but answering those seven questions honestly is a great place to start planning from. However, if your trading is not going quite as well as you would like, that is the time to revisit the list and decide if the plan failed, or you failed to plan well enough!
CFD Leverage Explained – Risk Management
At this point we hope that you now understand more about the benefits and risks of using leverage in CFD trading. Many traders who fail do so because they only concentrated on the profits they could achieve and ignored the obvious risks that are involved when you decide to misuse leverage in CFD trading.
Risks come in many forms and are compounded by a lack of knowledge or poor decision-making, both of which can be addressed. Some risk factors, like unexpected changes in the market, you can’t account for, but you can take steps to minimise their impact. You will never eliminate every risk, otherwise all traders would be very rich, but you can learn to manage them by using leverage appropriately and learning how to implement orders like Stop-Loss and Take-Profit correctly.
You also need to accept that no trader ever achieves a 100% success rate; a much more realistic goal for a new trader is aiming to make enough profit to cover your losses plus about 5% after expenses. If you are looking for the best broker for beginners UK regulated options are a good place to start.
If you understand CFD leverage explained in ratio terms, you can apply a similar ratio format to your profits and losses where 1:1 is your break-even point and anything over 1 on the profit side is a bonus.
Conclusion – Time To Try CFD Trading
CFD leverage explained in simple terms, allows you to open large trading positions using just a small amount of your own trading capital. Whilst this enables you to make your capital go further and increases your potential profits, it also means that losses are magnified, perhaps to the point where your account is emptied and money owed to your broker.
We cannot stress enough the importance of implementing a trading plan which includes risk management and continuous monitoring of your profit/loss ratio. By reading through our guide to leverage in CFD trading, we hope that you are now entirely clear about using leverage wisely to ensure that you are always trading within your means. Knowledge is power and that is what our trading guides are all about.
CFD Leverage Explained FAQs
❓What is CFD leverage?
Using leverage in CFD trading means you can open bigger trades with a small deposit. However there is much more you need to know about this subject than a single fact. To find out about the benefits and how to avoid risking your trading capital read our in-depth CFD broker reviews and trading guides, which centre on CFD leverage explained in simple language.
📈How much leverage can I use?
There are several different answers to that question. If you are referring to leverage capping, it varies according to the regulations imposed in your country of residence as well as your trading status. You will find lots of information about that and many other subjects in our informative guide to leverage in CFD trading. Check out our latest trading guide at Tradersbest.com.
💰How much capital do I need to get maximum leverage for CFD trading?
There is no fixed amount of capital and the maximum leverage made accessible to you depends on various factors. Leverage is not automatically offered to all traders and maximum leverage ratios vary according to the underlying CFD asset and the type of account you have with your broker, amongst other things. If you would like to learn more, then please take a look at our in-depth guide, which you will find at TradersBest.com.