If you’re a fan of trading with CFDs (contracts for difference), it’s important to be aware of how to use leverage safely. Some newer traders become overly excited when they realize that they have the power to purchase contracts that are up to 10 times the value of their account balance (assuming their broker offers them a 10 percent margin requirement, for example). It’s tempting to want to get the most out of whatever the platform allows in terms of leverage, but there are some very real risks involved. Fortunately, if you follow a few simple rules, it’s possible to dispel most of the disadvantages and make the most of your buying power at the same time.
How CFDs Work
Unlike standard securities accounts where traders have little or no ability to leverage their capital, CFD enthusiasts typically have the chance to use leverage. One reason these are so different is that contracts for difference are unique financial instruments. For starters, when you buy a CFD, you hold no assets, no stocks, bonds, metals, options, futures, or currency pairs. Instead, you’re a party to a contract in which you are making a prediction on which direction the underlying security’s price will go, up or down. If you guess correctly, you profit. Guess incorrectly and you take a hit. Sellers/brokers make their money on the buy/sell spread up front, so they’re technically no commission on the deal.
The Pros and Cons of Leverage
If you have a 10 percent margin requirement, it means you can purchase a $1,000 contract for $100. Obviously, if prices go your way, you could earn a nice profit for your small payment. And if things go against you, the loss could be substantial. This is the inherent risk when it comes to trading CFDs, no matter how experienced you are at trading. Both gains and losses can build up quickly unless you set careful stops to keep losses at a minimum.
How Stops Can Protect You
It’s essential to understand how to two basic stop orders can help you minimize losses and lock in profits. There are many different terms used to describe the two tools, but most traders call them stop loss and stop limit orders. Your platform might use other terminology, so be sure you know which is which, and understand how to use both. Here’s an example for each type of stop order.
If you purchase a CFD and the underlying asset is shares of XYZ stock, assume the current price of the shares is $50 and you’re going long, or betting that the price will rise. If you set a stop loss at the $47 point, the contract would automatically terminate and pull you out if the price of XYZ went down to $47. Then, if XYZ continued to slide downward, you would suffer no further losses. Assume the same set of circumstances as above, but in addition to the $47 S-Loss order, you also place a S-Limit at the $57 mark. It the shares begin to head north and reach $57, the S-Limit order automatically exits the trade and you pocket a nice profit.