A common but valid question in forex trading circles is “How to trade with leverage?” And which leverage is better: high or low? In this case, the possibilities of investors benefitting from increases or decreases in the value of an asset without actually owning it are limitless. This article puts forth the benefits and consequences of leverage in CFDs.
What is Leverage?
Leverage is a financial term referring to an instrument or loan that gives the user power of using borrowed funds. It signifies the ratio between the value of the instrument and borrowed funds.
When you trade on margin through CFDs, you are essentially leveraging your capital and earning much more than if you were to deal with all your funds. It means that for a relatively small deposit, say $1,000, you could open a much larger position in the market.
What is Contract for Differences (CFDs) trading?
Contract for differences (CFD) trading is a financial instrument that enables the holder to take advantage of the fluctuations in price between two currencies. It involves predicting whether the price will go up or down and then making a trade accordingly.
If you believe that the asset’s price will go up, you buy a CFD, and if you think it will drop, you sell. Thus, when entering into this type of contract, you predict which direction the market will move.
Benefits of Trading with Leverage
Using leverage in trading comes with two main advantages: Firstly, you can make more money because of opening larger positions. Secondly, you can reduce potential losses because you are not trading all your funds. In addition, using smaller margins allow you to manage your risk better, as you can take a more significant number of trades.
The Flipside of Leveraging
Leverage is double-edged as it is helpful but carries risks that are proportional to its benefits. There are setbacks with trading CFDs on margin:
As much as the potential profits are high when using leverage, so are your possible losses. In essence, leverage works differently for different people. Therefore, never use more leverage than you can afford to lose, as there are always high chances of losing money if something goes wrong.
If your losses are so huge that they exceed the deposit or margin available on your account, then a margin call will occur. As such your position will be closed and you will lose all your money. Such is the leading risk on trading CFDs on margin and why you should never trade on margin unless you can afford to lose your money.
However, you can reduce potential losses by using smaller margins to manage your risk better. Here, you can take a larger number of trades as opposed to trading with all your funds.
Role of Brokers in Margin Trading
Some brokers give incentives for trading on margin. For example, they offer special deals that include a rebate or return on deposit scheme based on trading volume or turnover over set periods. The volume rebate is a percentage of turnovers. As such, the higher the volume of trades, the higher the rebate on margin interest rates.
Some brokers allow their clients to trade with leverage without even requiring any deposits or margins. However, before considering this as a trading strategy, it is necessary to consider the risk of losing everything at once.
The bottom Line
Whether to consider leveraging a good move or not depends on a particular trader’s strategy. It is significant for every trader to understand how the broker works with margin and the risks inherent. Having a good trading plan before considering trading on margin prepares your assault on the markets.
It helps to consider trading as risky, and you should risk what you can afford to lose. There is a chance your losses will exceed your deposit, forcing you to pay money that you don’t have. As a result, you might lose your capital and the original margin you had put down for the trade.
It is paramount to note that leverage can go either way: If the market moves in your favor, you will make more money than if you hadn’t used leverage. But, conversely, if the market moves against your position, you will lose more money than if you hadn’t used leverage.