CFDs 101 - What is margin and leverage?

You may have heard about contracts for difference, or CFDs. That they carry additional risk but can work well for the agile, short-term trader. You know the type-fast movers, even faster thinkers. But you might not know what’s involved or how they work at their core.

Let’s dive in – in the video you will gain insights on the building blocks for using CFDs to trade the world’s financial markets – respecting but harnessing the power of leverage.

As we learned in the video, CFDs are contracts that pay the difference in the price between the opening and closing of a trade. What makes CFDs unique is that the trader doesn’t own the underlying asset, instead, they use borrowed money to place the trade on that asset, believing its price will follow a certain course.

This is called leverage – it is the most prominent feature of CFDs and if you have the risk tolerance, leverage is one of the overriding attributes for trading these products.

Now, leverage carries increased risk if the trader does not account for position size but generally speaking, regardless of whether the trader is looking at equities, indices, commodities, forex, or even crypto in some parts of the world, leverage is the very thing that sees them gravitate to CFDs over other tradable instruments.

Technically speaking, leverage is a function of the margin you put down to facilitate the trade. Where margin is the amount of money that you need in your account to open or maintain a position and represents a buffer against potential loss on a trade. Trading on margin means that you can have the full market exposure by depositing only a fraction of the trade’s total value.

As we heard in the video – Deena wants to open a Buy trade with 30:1 leverage. The USD notional, or face value of this trade is $100,000. So, in this instance, the margin required is $3333.

Without leverage, Deena would have needed $100,000 to be able to open such a position.

Understanding how leverage can influence your strategy is fundamental to trading.

We can adjust the degree of leverage depending on our risk profile and volatility in the market as well as whether we use a pro or retail account. But as a general view, leverage may fit the needs of some traders. Especially for those whose strategy may require multiple positions at once or who have smaller account balances, but still want the freedom to trade the world’s financial markets.

Benefits and risks of trading leverage

Allows traders to open multiple positions – highly beneficial if running systematic strategies that may result in taking a number of trades.
For smaller account sizes, leverage allows traders the ability to take positions they may not have been to in the futures market or direct shares.
Having flexible leverage rates allows trades the ability to be dynamic to fluctuations in volatility and manage risk more efficiently
Using leverage expose a trader magnified losses if the position moves against him/her
Trading with leverage is not suitable for traders without previous exposure/experience to CFD instruments.

Risk management

Leverage involves borrowing funds to gain larger exposure in the market with the use of a smaller amount of initial capital known as Margin. For a quick recap on the basics, see our video ‘CFDs 101: What is margin and leverage?’

Being able to trade CFDs using leverage offers the ability to trade all market conditions, especially through shorting. However, having access to larger market exposure means even slight market movements can result in larger profits or losses. Here’s a short video that explains this further.

Let’s look at the benefits

First of all, leverage opens up the ability to access markets previously enjoyed only by the big money players because historically gaining access to these markets required large amounts of capital.

Leverage allows the trader’s account capital to go further. By placing a percentage of the account as a margin, you can subsequently get multiple positions on various contracts. Which leads us into the third benefit-

Diversification. More positions allows different positions, reduced correlations and more trading strategies to play simultaneously.

And finally, Leverage opens up a new world of opportunity for traders wanting to express a view, their way, long and short, across an extensive product range such as forex, equities, indices, commodities and ETF CFDs.

What are the Risks?

However, leverage is not without its risks and can magnify two key mistakes retail and even pro traders typically make-

The first is overconfidence: If your trading goes through a run of good form you may overestimate your ability to predict the markets. This would lead to you increasing position size or your leverage. Subsequently, if the market were to turn and a trade goes against you, it could lead to a bigger loss.
Over trading: With greater flexibility to trade, the greater the freedom to place more trades – this can lead to increased transaction costs if not dealt with in a disciplined way.

Consider the sizes of your trades relative to your account balance and risk appetite and always consider tools such as a Stop Loss when trading with leverage.

Why use CFDs in your daily trading?

Contracts for Difference or CFDs open up a whole new world for traders.

Many traders use CFDs daily, because unlike other tradable instruments, CFDs are a simple, cost-effective way to trade across an extensive range of markets powered by greater access due to leverage. Let’s take a look.

Key Characteristics of CFDs

There are two key characteristics of CFDs that make them suitable for daily trading.

The first is Greater access
This approach to trading was once restricted only for institutional traders or large accounts as leverage carries additional risk, especially if market volatility and position size are not carefully considered. Now times have changed and through platforms such as Pepperstone, the everyday trader can take advantage of leverage, accessing market movements they previously weren’t able to unless trading options or futures which have their own complexities.
The ability to hold more positions at once
CFDs allow trades without holding the underlying asset, meaning, the trader is simply expressing a directional play on the market over a duration of their choosing without actually having to own the underlying asset.

Four Key Advantages of CFDs

For those who watch the clock, there are four key advantages.

Greater leverage means you can take up more positions; however note that greater leverage carries increased risk and will require attention to position sizing
Low cost. For the active trader CFDs can be incredibly cheap vehicles to trade the world’s financial markets
With such an extensive range of markets – many trading 24 hours – wherever the move takes place, you never miss an opportunity
Flexibility – You can simultaneously hold long and short positions in order to capitalise on bull and bear markets.

CFD explainer: How liquidity affects your trading

Liquidity. It may be one of the most crucial factors in trading. In essence, it is the volume available at the quoted price which dictates the ease with which a trader can get in and out of a position, and without having to move down the order book to achieve a fill at the next best price.

How does market liquidity affect your trading?

From a market perspective poor liquidity is typically a function of rapidly shifting conditions, uncertainty and other macro-related issues. In illiquid periods, large orders by big money participants can exacerbate movements in price which affects the trading conditions for everyone.

From the perspective of a trader, liquidity determines how easily you can get your order filled at the displayed price. Some brokers will display incredibly tight spreads but when you hit the buy price your actual fill may be slightly different, as the volume they provide to buy at that price is very small, so they fill the balance of the order at the next available price.

This is called ‘price slippage.’ Slippage is often observed in cases of brokers not offering adequate liquidity or in an illiquid market.

Here’s how it works

Jennifer wants to buy 3 lots of EURO-DOLLAR and her broker’s bid-offer spread is 1.05000 – 1.05002. Jennifer hits the buy button at 1.05002 but evidently on her account history she sees her trade entry price was in fact 1.05005 – because the broker had such poor liquidity at the quoted price she experienced ‘slippage’, with the broker working the request at the next best price to get a volume weight average price.

For traders, especially higher volume traders, it’s a cost you simply don’t need. Pepperstone places great emphasis on providing exceptional liquidity conditions so that the chance of slippage and related trade costs are both reduced.

How to: survive and thrive in a high volatility regime

Volatility is by far the most important variable in trading. Not only can it determine what market you trade it also holds sway over the direction and duration of trade. It is a key metric because volatility creates opportunities and determines your risk and position size.

While traders typically find volatility a positive attribute and welcome a lively market, everyone should adapt to changes in daily ranges and movement. Those who do can flourish, and those who don’t end up paying for it. Watch this video as we explain volatility.

What is volatility

Volatility is an investment term that describes sharp price movements away from a set mean in a market or security. People often think about volatility only when prices fall, though volatility can also refer to sudden rises in price too.

How to read volatility

There are a host of tools and even tradable instruments to read changes in volatility. Many traders will simply use price action to understand the trading range, but others use Average True range (ATR), standard deviation, Bollinger Bands, Keltner bands and the US volatility index or VIX. How you interpret or use these will be down to your trading system but they can help you with your risk and achieving correct position size.

Watchpoint: increased vol = increased risk

Of course, increased volatility brings increased risk. Add to this the use of leverage and the risk factor goes up again. So while there may be more opportunity, if traders aren’t dynamic and adapt their approach to volatility, it can be costly.

How to mitigate risk with Pepperstone

With Pepperstone, you can mitigate risk and more confidently navigate volatility. Here’s why:

Pepperstone has a range of trading platforms which have access to all the indicators, oscillators, and tools you need to identify changes in volatility and trends in a market. All with the very best insights, news and views to help you with your trading.
Our charting offers signals and alerts to traders, complementing a suite of advanced order execution and risk management tools at your disposal, including correct position and size calculators.

How to: trade Forex (FX)

We see a world where capital is moving continuously from one jurisdiction to another – all for different reasons. For some it’s speculation, for others there is a need to buy and sell currency for investment or business purposes. The trader’s job is to create and master a process which can sustainably grow the capital in the trading account from this dynamic. Let’s unpack this cosmopolitan market.

What is the currency market?

Forex, short for foreign exchange, refers to the trading and exchange of one currency for another.

This exchange is happening 24 hours a day, 5 days a week.

We’re talking some $6.6 trillion a day in volume of all currencies being swapped and traded between two entities. This is done for a myriad of reasons, such as: the need to buy or sell currency for trade & commerce purposes; to hedge currency risk; or to speculate on a direction. This international flow, centred on the demand and supply, creates huge movement in exchange rates.

Why do CFD traders gravitate to Forex trading?

Well, some of the more inviting reasons to trade FX include:

It’s open 24 hours a day so there’s no gapping risk
It’s cheap to trade, because there are very tight spreads
FX features good levels of movement on an intraday basis and is
highly liquid meaning it’s easy to get in and out of positions even in large size, plus with
the low gapping risk and low costs, it is a favourite for automated traders

How to: trade Gold CFDs

Is there anything more appealing than gold?

Gold wears many hats. At times, it’s a hedge against inflation; at other times, it’s a hedge against economic fragility or simply the anti-USD.

While the catalyst of gold moving up or down is subject to much debate, one thing is clear: gold has a truly loyal following from investors and traders alike.

How to trade Gold CFDs

Trading gold CFDs effectively requires an understanding of the market for gold, in addition to a basic grasp of CFD trading.

Strong signals to look out for when trading gold are the near term direction of the US Dollar, moves in the US bond market and even uncertainty in the stock market or other forms of financial and economic hardship which might drive investors to head for the hills.

Aside from these externalities, gold CFDs can be traded using a fundamental framework, statistical data or charting techniques to determine potential price direction.

Gold, as with most assets, tends to trade in cycles, so tapping into the progress of these cycles by analysing previous pricing data can give traders the signal they need to jump on board with a position in the gold market via CFDs.

Approaches to trading gold CFDs

There are two approaches to trading gold CFDs.

Aggressive daily trading
Given the near 24 hour nature, tight spreads and excellent liquidity, scalpers and day traders gravitate to gold. With the ability to trade higher frequency short time frames traders can go in hard and get on with other factors in their lives or even automate this process
Play the currency angle
While most clients trade gold priced in US dollar terms, Pepperstone offers gold denominated in British Pounds (GBP), Aussie Dollars (AUD), Euros (EUR), Swiss Francs (CHF) and Japanese Yen (GPY). By having gold priced in alternative currencies, traders can attempt to maximise the returns. Traders should look to buy gold in the expected weakest currency or short gold in the perceived strongest currency this is a unique offering from Pepperstone with very few other brokers offering these products.

How to: trade Energy markets

Crude, natural gas and gasoline are never far from the headlines. Energy commodities are some of the most important markets in the world. They set the price for our everyday consumption of the massive volume of fuel required to live and run a business today. Energy CFDs allow traders around the globe the ability to trade crude oil, which is the most liquid and commonly traded commodity. Here’s a video of how you can trade Energy markets with Pepperstone as CFDs.

The appeal of energy CFDs

Spot crude trading is out of reach for the majority of traders, but through SpotCrude and SpotBrentCFDs, traders can bypass the requirement of dealing with a physical commodity. Instead, they can speculate on the future market movements of energy assets, with the flexibility of leverage and without the interest and holding costs that are priced into crude futures markets. Traders will pay an overnight funding charge though if they hold past the cut off time.

Energy CFDs: Advantages

What are the advantages of energy CFDs?

Trade the headlines – As macro events can have a direct impact on global markets, clients can trade news events and how it affects energy markets nearly 24 hours a day, 5 days a week.
A great market for all trading strategies – trend-following, momentum and mean reversion among others. For those who see advantages in big movement in their trading, then energy often has it in spades
Increased flexibility – traders can trade long or short, meaning they can express a view on energy commodities if the price is rising or falling.
Regulation – Clients trading with a regulated CFD broker are offered specific investor protections according to local regulatory requirements.
Reduced drag – Transaction costs can wear on your portfolio. Pepperstone offers a competitive cost structure to trade CFDs.
With Pepperstone, clients can express a view – either long or short – on the world’s most popular energy commodities, including Spot Crude, Spot Brent, Natural Gas, and Gasoline- as well as a range of energy related ETFs and energy equity CFDs.

How to: trade Global Equity indices

For some traders, market indices are their vehicle of choice. But what are they and why are they appealing?

Trading Cash Equity Indices allows you trade the movement in a range of Global equity indices removing the interest and dividends that are priced into the equity index futures. In essence, you simply trade on the index’s price movement. For CFD traders, indices are one such vehicle to easily express a trading view – long or short – over any timeframe. Could they become your vehicle of choice?

Understanding how market indices are constructed and utilised can help add meaning and clarity to a wide variety of investing avenues. Let’s see how.

Index composition definition

Let’s unpack the composition of an index. An equity index is really a basket of stocks.

For the large majority of markets these stocks are either weighted by their market capitalisation or for the US30 and JPN225 by their price.

In most cases, the larger the market cap, the greater the weight and influence on the index.

For example, as of May 2022, Apple had a market cap of $2.42 trillion and it subsequently has an dynamic index weight on the NAS100 of 12.5%. Microsoft is at 10%. We know that if news impacts either stock and we see a strong move it will subsequently have a big impact on the NAS100.

Why CFD traders gravitate to Index trading

So why do some CFD traders focus on Global Equity Markets?

Some indices are open 24 hours a day or near 24 hours, limiting the risk of gapping. If big news drops when the New York Stock Exchange is closed, having access to a near 24-hour index CFD means you can react in real-time and not miss an opportunity to open or close a position.

They also have good levels of movement on an intraday basis, have highly competitive spreads and they offer fantastic diversification from single stocks.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75.3% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money

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