CFD stands for Contract For Difference and it is a leverage trading product where retail traders can access leverage products such as Stocks, Forex, and Cryptocurrency through regulated or offshore brokers.
When you open a position with this type of trading platform you only put down a small fraction of your own money when entering the market. For example, traders with smaller accounts can trade lot sizes of up to several hundred thousand with a deposit of only $500.
The money lent to you is paid back to the broker once the position is closed out, either for a profit or a loss.
The added funds you receive to open the trade can not be lost and you don’t have to worry about owing the platform anything if you suffer a loss.
This style of investing is a very powerful tool for traders who lack the funds to generate sufficient and steady profits in the financial markets.
CFD leverage trading is used by both retail traders and professional traders who are looking to amplify their profits up to 10 or even 100 times. Since you are only asked to add a small amount of capital upfront, you can decrease your overall risk of losing money by using less margin.
- CFD trading with leverage can result in very large profits, even with a small account. However, this comes with the added risk of losing more money fast.
- With CFD trading, traders can enter the market with only a small fraction of their own money and trade larger lot sizes.
- The borrowed money is paid back to the broker once the position is closed, whether it’s a profit or a loss.
You will learn
CFD Leverage Explained
CFD leverage is the amount of borrowed money you receive from your CFD broker after depositing your margin capital.
This directly translates into morex buying power and bigger position sizes which can result in handsome profits if you predict the market correctly.
Before opening this kind of trade you are asked to choose your ratio, the position size, and of course all the other necessary details such as order type and price.
The platform then calculates your margin capital and adds the missing money that is needed to open your position.
For example, if you have deposited $1000 in your account and you wish to open a position of $10.000, your margin capital will be 10% of the position size and the rest is the credit that the CFD broker provides you.
Here is an example of how leverage works:
- Joe has $500 and he wants to trade the forex pair EUR/USD.
- He opens an account with his regulated local CFD broker and deposits the money.
- Once the KYC process is done and the money is in his trading account he can now start to use the credit offered.
- Now Joe can enter the forex market and choose his position size, price, and order type.
- With the leverage that his platform provides, he can open a position for $20.000.
- $500 is his own margin capital and the rest ($19.500) is the extra buying power he receives when opening the position.
- Joe buys EUR/USD after predicting that the market will rise in favor of EUR.
- Joe is correct and collects a profit of +1.50% after a large breakout.
- His profit is $300.
- When he closes out the position he is left with his initial investment of $500 plus the $300 in profit.
- He now has a total of $800 in his account.
- The borrowed money used in to open the trade is returned to his fx broker once he closes the position, this happens automatically.
This is a normal case of how to trade the fx markets with added buying power. Your trades will not always end up as successful as Joe’s but if you read the market correctly you can collect windfall profits in a very short period.
This of course comes with some added risk factors and I recommend that you read our guide on risk management in leverage trading before starting out.
How does CFD leverage work?
The concept of using borrowed money to amplify profits has been around for a very long time. It’s very popular to leverage long-term investment portfolios for large investment institutions so it only makes sense to offer this style of investing to retail traders as well.
The process of accessing the borrowed capital is completely automatic and you as a trader don’t have to worry about where the money comes from or how it reaches your account.
This is done behind closed doors through liquidity providers that your trading platform is contracted with.
In a nutshell, here is how CFD works:
- The first step is to find a broker that offers extra capital and create an account.
- Select the market you wish to trade.
- Choose your position size and credit.
- Open your position and use proper risk management.
- When you close the trade, all your profit is yours to keep and the rest of the borrowed money is returned to the trading platform.
- If you lose out on the position, the money will be collected from your initial deposit or margin capital.
Not all platforms will let you choose how much added buying power you want to use and in this case, you need to control your risk with your position size.
For example, if you deposit $1000 and you have access to up to $100.000 of trading capital, this means that your broker is giving you a ratio of 100x margin.
This might be too much for a complete beginner and in this case, simply reduce the position size to make things easier. Once you find your sweet spot you will find that it’s a joy to trade with borrowed funds if you keep your risk under control. It’s all about letting your winners run and cutting your losses very fast.
No, the leverage is automatically returned to your broker, and the losses are deducted from your margin capital.
Why leverage is important in CFD
This is a very good question that many traders and investors are asking, is it really necessary to use leverage while trading the financial markets and why is it offered in the first place?
- The first thing that comes to mind is that with a small fraction of a position size, you can enter markets in a big way that has previously been impossible. This creates a big opportunity for retail investors and traders who don’t have thousands of dollars or even tens of thousands of dollars on their hands.
Many aspiring traders start on a CFD platform and those who are skilled make money rather quickly thanks to the leverage provided to them. When they first step onto the trading floor and enter the market they might have an account size of $500-$2500 and once they start making good trades with large position sizes their account groves rapidly. It’s not uncommon for a trader to go from a 4-digit account to a 5-digit or even 6-digit account size throughout a couple of years. This is of course very difficult to achieve but if you have the skills and are willing to put down the hours necessary it’s a possibility.
- The second reason why margin is important in CFD trading is if you have a small account and want to spread out your risk and try different strategies for margin over several markets. Many traders and investors compare forex vs crypto vs stocks and decide which one to focus on after testing out the water for a couple of weeks or months. If you use leverage you can afford to use a small piece of your margin capital in one market while you use the rest for another market.
- The third reason is that without credit the platforms would not be able to compete against other brokers that don’t offer this type of borrowed money. This is what makes them unique and if you would remove the added buying power it would simply be a regulated stock exchange that offers contracts that are not the actual stock, forex pair, or cryptocurrency itself. All contracts traded on a CFD platform are mirrored contracts of the actual price of the original contract. So, if there was no leverage, there would be no platforms.
How much leverage is offered in CFD?
This is a question that so many traders are asking and I understand why this is interesting. Some companies offer up to 5000x leverage in their fx trading pairs. To me, this is outright crazy but some traders out there want to take the bull by the horns and ride out the market in a wild fashion.
Through regulated and reputable CFD brokers, borrowed funds is offered from 10x, 20x, 50x, 100x, and up to 500x.
A ratio of 1:500 is an extreme ratio and I don’t think beginners should start at this level when they are entering the market for the first time.
A good leverage for a beginner is around 1:5 to 1:30 depending on the market and the time frame of your strategy.
It’s crucial to learn how to choose forex leverage if you are a beginner to avoid over-leveraging and wiping out your account.
Below is a table of a couple of popular CFD platforms and the margin they offer:
These are all globally regulated and trusted brands and they all offer ratios of several hundred. Many of the platforms only offer the maximum amount of leverage to professional clients.
These are clients who can prove that they have sufficient funds and education in trading the financial markets. If you apply for a professional account you can take advantage of extreme credit trading in forex, stocks, and crypto.
Before testing this out I recommend that you demo trade on a broker that offers a demo account to test out which ratio is best suited for you. If you are not careful enough and jump on the most extreme ratios straight off you risk liquidation which will cause you to lose all your funds.
Most brokers nowadays offer negative balance protection which will protect your funds from ever going negative. This will prevent you from going into debt with your provider.
CFD trading is outright banned in the United States while still being operative in many other countries.
Now, is leverage trading legal in the US at all or are all types banned?
Forex, crypto, and stock trading on margin remain legal in the US as long as the broker that offers leveraged services is approved by the NFA.
Benefits of leverage in CFD trading
Traders use borrowed funds for many reasons but some factors make it worth the hassle. I have listed below the biggest benefits that I can think of and if you agree with these points you might as well try it out.
- Amplified profits – The biggest benefit that attracts most investors is the profit boost you get from trading with borrowed funds. It is not uncommon to make profits of up to $1000 or more per trade, even with a small account of only $200. This is a direct effect of using larger position sizes than normal and when you read the market correctly you get rewarded for the size of the position.
- Enable several strategies – Many traders are one-trick ponies, meaning that they only trade one setup, and that is perfectly fine. But for those investors who rely on spreading out their risk capital over several markets and strategies, borrowed capital comes in very handy. With this added buying power, a trader can afford to trade more strategies over several markets which might mean a better risk profile and perhaps better results.
- Spread out risk – They say “don’t put all your eggs in one basket”. This is a common trading quote that holds true for all investors. With leverage, you can truly spread out your risk even if you trade a small account size. For example, if your account is worth $500, you can spread it out over five different positions or markets to diversify your strategy. This means you have $100 of margin capital per underlying asset which can translate into well over $5000 per position.
- Short selling – Through CFD platforms you have the option to bet against the market, or short-sell as it is more commonly called. This means that you are betting on a negative market and if you succeed in your predictions and short-sell as the market is falling, you are making a profit while other traders are losing out. This is mostly a short-term trading strategy but it is very effective in sour markets.
- Option to hedge your position – As mentioned in the point above, short-selling enables the hedging of positions that you think might be in trouble. To hedge a position means that you are betting in both directions with an equal amount. For example, let’s say that you are long JPY/USD and you think that the Yen will fall during the next couple of hours, then you can short-sell JPY/USD at the same time and collect a profit if the market falls. Once you close out your short position, the hedge stops.
- No expiration dates – When you trade on a CFD platform, you don’t trade the original underlying asset. Instead, the contracts you trade, Contracts For Difference, are mirrored contracts of the original security. For example, you can trade Tesla with leverage without owning real stock. This also means that you don’t need to think about expiration dates. Expiration dates are commonly used in futures markets and options markets that also offer leverage.
- Very flexible lot/position sizes – Varying your lot size can be incredibly powerful when you trade a hot market. For example, you can enter the market in small increments and increase your position size as the market moves in your direction. This strategy is one of the most popular and most rewarding trade management systems and it can easily create a “snowball effect” that doubles or even triple your profits.
Other traders also ask
CFD stands for Contracts For Difference and is the contract offered by the broker. Leverage is the multiple of added buying power to your positions based on your margin capital.
Yes, they do. However, they are very selective in their trades and they don’t blindly enter the market. Due to the volatility and their trade size, they choose their entries with precision and exit the market at the slightest sign of weakness in the market.
This guide has been a tutorial on CFD leverage as well as an explanation of how the trading part works. As you read this article you will gain an understanding of how the platforms work, how they operate, where the credit line comes from, and also the biggest benefits.
You will also learn what ratios are available on the different platforms and also some general tips to take away before you start.
There are many reasons why you would want to leverage trade CFDs and some of the most important reasons are outlined in this guide.
As a beginner, I recommend that you read this tutorial in full to learn the basics before you enter the leveraged markets.
Other similar articles: