Trading CFDs With Leverage
Investing in the stock market can take several forms: trading in shares and market indices or trading CFDs on stocks or futures contracts.
1. Firstly check what the underlying instrument is, or the one whose price is reflected by our CFD. Typically, this is a futures contract listed on a stock exchange.
2. Each contract has a certain specification set by the stock exchange. It is important to verify key details: what is the precise meaning of the price given and what is the size of the contract?
For example, the price of gold is given in dollars per Troy ounce, (approx. 31 grams), but the contract is for 100 Troy ounces. The price of wheat is given in cents per bushel, (approx. 27 kg), but the contract for wheat is for 5,000 bushels.
3. One CFD frequently corresponds to the size of one futures contract on which it is based, but allows concluding transactions with a nominal value of 0.01 of the contract.
4. All the necessary information is available in the Financial Instrument Specification. When selecting the size of the position it is suggested you use a deposit calculator.
5. Trading in the stock market is done using a trading platform. The first step is to organise your individual platform workspace. There should be a chart of the instrument that you are interested in, the market window (where you can see the quotations of other instruments) and a window where all open and pending orders, along with their parameters, are listed.
Leverage is a very important concept when trading on the derivatives market. It allows investments to bring much higher returns, but also entails some considerable risks. Let's use an example to understand this further.
If we buy gold with a value of €10,000 from a jeweler, we have to pay them the whole amount – €10,000. Investing in a contract for gold with leverage, at 3% of a deposit margin for example, we only need to pay €300. In this trade we do not become the owner of the gold, only a party to a CFD transaction. When the value of gold changes by 1%, i.e. €100, our capital will change by the same amount. A change by €100, at €300 invested, would mean either 33% of profit or loss, even though the price of gold has only changed by 1%. This means leverage at 33/1 (a one-percent change in the price of the underlying instrument – gold – contributed to a change in the value of our deposit by 33%). But leverage should be used extremely carefully, or we risk losses that can exceed our deposit.
Being a party to a transaction in a CFD contract does not involve physical buying or selling. Only a deposit margin is blocked on our account and we control the open position. Conventionally these are called either a position of buying (also known as a long or a buy) if you want to make money on the price increase or a position of selling (a short or a sell) if you want to earn from a price decrease. If the margin is a very high percentage of our capital, investing in the stock market may not be wise as our position can be automatically closed as a result of unfavorable changes in prices. Let's return to our example to understand this further.
Let us return to the example of gold and suppose that we had exactly €300 in our trading account. If the price of gold initially rose by 1%, our account would show €100 of profit, i.e. the valuation of our account would total €400. The deposit required for our open position remains unchanged at €300. This means that we are using 75% of our capital – too much for wise, rational investing in the market. Why is this the case?
Suppose now that the price of gold goes back to its initial level. This means the valuation of our account also falls back to the initial €300 we first invested. At this point, we are using 100% of our capital as the margin deposit, which is also the required security deposit. After further losses our funds no longer meet the requirements of the deposit (3% of the gold's value), and we will receive a margin call. This is a request for us to supplement our investment to the level of the maintenance margin, or close the position. If losses continue and the valuation of our account falls to or below 50% of the required deposit, our position will be closed automatically. In this example, if the price of gold falls by 1.5%, the valuation of our account will be €150 – half of the required security deposit of €300. In this situation, our investment is closed with a heavy loss.
Why It Makes Sense To Risk Only Small Percentage Your Capital?
Even if you correctly foresee the direction of price changes, it is impossible to accurately predict the moment when the changes will happen. This is a fundamental rule of trading to learn, as ignoring it makes a position vulnerable to shake-out. Our position must be able to survive small price fluctuations. With a high leverage, this may not be possible and we may incur a loss on an adverse excursion in market price even though the trade idea may have been correct and eventually played out as expected.