Leverage allows a client to trade without putting up the full amount. Instead, a margin amount is required. Traders use leverage to significantly increase the return on a CFD investment. Simply speaking, leverage is a loan that is offered to an investor by the broker that is handling his or her account. Leverage varies according to the instruments.
Common leverage amounts offered by most brokers:
Up to 1:400
Up to 1:200
Up to 1:200
Up to 1:50
Examples of leverage trading
You decide that you want to buy Google Shares. Instead of purchasing 1,000 Shares of Google from a Stockbroker, you buy 1,000 CFDs of Google on a trading platform. If there is a $4 per share fall in the price of Google, you would receive a $4,000 loss. However, if there is a $4 per share rise in the price of Google, you would receive a $4,000 profit, just as if you had purchased the actual shares.
With a deposit of $1,000, your equity is $1,000, leverage to trade forex: 1:400. Your total to trade with is $1,000 x 400 = $400,000
You open a trading account with $5,000 as margin, which is the collateral or equity in your trading account. Your leverage is 50:1 for major currency pairs. This implies that you can put on a maximum of $250,000 ($5,000 x 50) in currency trading positions.
In online trading, the word margin is used to describe a deposit used as collateral for taking positions in the market. Trading with margin allows traders to basically open positions on credit – increasing the client’s buying power.
When a trader trades on margin he uses a free short-term credit allowance from the broker. This short-term credit is used to trade volumes that greatly exceed the monetary value of the trader.
Margin serves as collateral to cover any losses that you might incur. Since nothing is actually being purchased or sold for delivery, the only requirement, and indeed the only real purpose for having funds in your account, is for sufficient margin.
CFDs allow a trader to go short or long on any position using margin. There are always two types of margin with a CFD trade
- Initial Margin – (ranges from 3% to 30% for shares/stocks and 0.5% – 1% for indices, FX and commodities).
Initial margin is essentially a deposit. Take for example, large and highly liquid stocks such as Vodafone the initial margin will be nearer 3%, and depending on the broker and the client’s relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher. Initial margin will always be deducted from a customer’s account and replaced once the trade is covered.
- Variation Margin – (‘marked to market’).
Variation margin is applied to positions if they move against a client. For example, if a CFD trader were to buy 1,000 shares in Twitter stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £100 in variation margin (1,000 shares x 10p) from the client’s account. Note, this is all done in real-time as the market moves lower, so called ‘marked to market’. Conversely, if the share price moved higher by 10p the broker would credit the client’s account with £100 in running profits.
The Spread is the difference between the bid and the ask price of a security or asset.
Let’s say your broker quotes EUR/USD at 1.5602/05, this means that you can buy 1 EUR from him for 1.5605 USD or sell him 1 EUR for 1.5602 USD.
There are basically 2 types of spreads, fixed and variable.
- Fixed Spreads
A fixed spread never changes. This helps the trader plan their trading costs more effectively as they already know how much the bid and offer prices will differ when they place a trade. The spreads will remain the same, even when new events are taking place, usually a time of extreme volatility. The broker could offer a 2 pip spread on the USD/JPY as an example. This can be useful when you are trading the shorter time frames as the amount you have to overcome in spreads is constant. This allows you to know ahead of time that you need at least 3 pips gained to make a profit against the above example as you trade.
- Variable Spreads
A variable spread simply means that you will receive the best bid and offer prices that your broker can find in real time. In times of high liquidity, the spread on these brokers tends to be lower. This makes trading through them more cost effective, but also comes with the risk of market conditions at times. Let’s say, during Asian trading the above mentioned USD/JPY pair might be lower than the 2 pips, perhaps something like 1 pip. This makes for cheaper trading costs, which is always a plus. However, during a market announcement the spread might widen as the amount of orders shrink in the marketplace. For example, during the Non-Farm Payroll announcement out of the USA, this pair could very easily have a 20 pip spread. Variable spread brokers are extremely difficult to trade with during times of important market announcements.