What do leverage and margin mean when you are trading CFDs? In this article, you will discover how both leverage and margin work when trading CFDs.
Leverage and Margin are general trading concepts that can apply in a variety of trading and investment situations — in this article, we are focusing specifically on leverage and margin for CFDs.
- Leverage refers to the ability to use an amount of money to command a larger value of a financial instrument.
- Margin is the amount of money required for an open position.
- The higher the leverage is for a trade, the lower the margin requirement, but the higher the risk of loss.
Read on to find out more about how this works.
Leverage: the use of credit to enhance one’s speculative capacity
Merriam Webster Dictionary
How margin works in CFD trading
Let’s go through a worked example to illustrate how CFD margin works.
Suppose that you are interested in trading shares in Cisco Systems. You check the market price and shares are available to buy at $56.60 per share.
For the purposes of the example, let’s say you think Cisco’s share price is set to rise and decide to buy 100 shares as a CFD. You trade at a price of $56.60.
Now, if you were buying these shares through a conventional stockbroker, you would have to pay the full value of the stock when the transaction settled. If you bought, say, 100 shares, this would be:
100 shares x $56.60 = $5,660
When you are trading CFDs, though, you only have to deposit a portion of the stock value, and this is known as margin. It’s like putting down a deposit. This is why this type of trading is sometimes known as margin CFD trading.
Tip: CFD margin only represents a small part of the underlying value that you are commanding.
Margin rates for CFDs
The margin rate will depend on which security you trade and will determine how much margin you need for a given underlying trade value. For Cisco, you might trade with a margin rate of 20%, meaning your margin would be one fifth of the underlying value.
How to calculate CFD margins
The CFD margin required is simply the margin rate multiplied by the underlying value of the trade.
In our example, the value of the shares you are buying is $5,660.
Buying the shares as a CFD trade with a margin rate of 20%, your required margin would be:
$5,660 x 20% = $1,132
Share prices are changing all the time. If the price moves enough in your favour, you will be sitting on a running profit, but if the price moves against you, your position will be running at a loss. This may mean you have to provide further margin to keep the position open.
Make sure you understand the risks involved.
What is leverage in CFD trading?
Because margin CFD trading means you only need to deposit a portion of the underlying value of the security you are commanding, there is a resultant magnifying effect of your profits or losses relative to the amount of money you have put down. The effect is known as leverage.
If you are trading with a CFD margin rate of 20%, then your CFD leverage is a multiplier of five. Let’s work through the numbers to see why.
How leverage works in CFDs
Consider the following example:
One investor decides to buy $12,000 worth of shares in American Express through their stockbroker in an unleveraged trade. Another investor decides to do the same transaction, but in the form of a leveraged CFD trade.
The unleveraged investor pays the full value of the shares, $12,000.
The CFD trader has a choice of leverage available to them and opts for leverage x5. This means their margin for the trade is just one fifth of the total exposure. The total exposure is $12,000 and their margin is, therefore, $2,400 (12,000 ÷ 5 = $2,400).
Imagine now that the share value changes by $900.
| Unleveraged investor | CFD trader | |
|---|---|---|
| Money deposited | $12,000 | $2,400 |
| Change in value | $900 | $900 |
| % change in value | 7.5% | 37.5% |
The percentage change is 5x larger than the unleveraged investment. Note: this applies to both profits and losses, so, there is an increased risk, just as your potential losses are magnified by leverage, so is your potential to profit.
Using the numbers above, if American Express fell in value by $900, the unleveraged investor would have lost 7.5% of the money they put down, whereas the CFD trader would have lost 37.5% of their deposit.
Final thoughts
Margin and leverage are aspects of CFDs that offer a trader the power, convenience and additional risk of commanding a larger value of a security for a given amount of cash than would be available through an ungeared investment — this cuts both ways, offering the potential for magnified losses as well as profits.
Visit the eToro Academy to learn more about leverage and margin and trading CFDs.
Quiz
FAQs
- Can I choose how leveraged my position is?
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Yes, you can choose your leverage from a range of available options to suit your risk profile and in accordance with the leverage limits on opening positions which vary according to the volatility of the underlying investment.
- Are margin rates the same for all securities?
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No, margin rates will vary according to the type of instrument.
- What is the difference between gearing and leverage?
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Leverage and gearing are interchangeable terms when it comes to CFD trading. A geared or leveraged CFD trade multiplies your potential returns, but also multiplies your downside risk.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.