CFDs are leveraged derivatives.
We’ve already discussed how CFDs are financial products in the form of derivatives.
These derivatives enable retail traders to speculate on the changes in an asset’s price, without owning the asset itself.
Another prominent feature of CFDs is that we trade them on margin, which provides leverage.
Trading with leverage means that you can open a large position size without having to put up the full amount.
Let’s say you wanted to open a GBP/USD position equivalent to a standard lot (100,000 units).
Without leverage, you’d have to put the full cost upfront.
But with a leveraged product like a CFD, you might only have to put up 3% of the cost (or less).
This means that you can open a CFD position, while only putting down a small percentage of the value of the total position size as a deposit (“margin”).
The amount of money required to open and maintain a leveraged position is called the “margin.”
It represents a fraction of the position’s total value or size.
When trading CFDs, there are two types of margins.
If you fail to maintain the margin requirement of your trade, you will receive a margin call from the CFD provider asking you to deposit more funds in your account.
If you don’t, the position will be automatically closed out and we will realize any losses incurred.
We know this as “trading on margin“.
For example, for a CFD contract with a leverage ratio of 50:1.
This is a margin requirement of 2%.
You would only have to deposit an initial margin of $200 to gain exposure of $10,000 worth of EUR/USD.
A leverage ratio is a ratio between the total notional CFD position value (that to which the retail trader is exposed) and the amount deposited by the retail trader (the initial margin requirement).
You are effectively “borrowing” the other 98% of the value of the CFD.
Profits or losses are based on changes in the value of the total position size (or “notional value”).
This means that although you only pay a fraction of the total notional value of their CFD position, you are entitled to the same gains and losses as if you paid 100% of the total notional value.
For example, if the total value of your initial position in a CFD trade is £10,000 and the leverage ratio offered by a firm is 100:1, the initial margin requirement for you would be set at 1% of £10,000, so you would need to deposit £100.
A market movement of 0.5% against your position, originally valued at £10,000, would result in a 50% (£50) loss against your deposited margin.
The leveraged nature of the CFDs means that retail traders can be exposed to losses exceeding their deposited funds.
Depending on the leverage used and the volatility of the underlying asset, the speed and volume of the losses can be significant.
We commonly see leverage ratios of up to 500:1 for forex CFDs.
With a leverage ratio of 500:1, a retail trader may open a CFD position worth $1,000,000 with an initial deposit (“margin requirement”) of just $2,000!
Such high leverage ratios make CFDs particularly price sensitive.
In fast-moving markets, prices can gap and losses can exceed the initial deposit.
Many retail traders can (and do) go into a negative account balance.
This means you can lose all your money and owe more money to your CFD provider.
Leverage is what makes forex trading appealing.
This is because it enables traders to open larger positions than what they can afford with their own money.
Doing this increases the potential for huge returns.
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