What has made CFDs so popular is that they can be used with leverage, for example at a 10:1 ratio. In this example, using leverage traders only need to deposit one tenth of the CFD contract’s worth. Some CFD providers offer even smaller deposit requirements when dealing with assets that trade at a high volume.
The result is your profits can be higher with less initial investment because your buying power is ten, twenty, or thirty times the size of your deposit. Obviously losses can be greater as well, and both gains and losses can easily surpass the original investment amount
It is worth looking more closely at CFD leverage and its consequences before moving on. The entire concept of leverage came about in the last few decades as an answer to the increased demand of markets to raise their level of risk and attainable profit.
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Conventional academic and market thinking equates leverage to ratios of debt (borrowing, debentures, etc.) and equity (assets, both tangible and intangible) funding an enterprise. Businesses considered to have high levels of leverage are those with a large ratio of debt to assets, meaning more risk and more return for shareholders.
In recent times, leverage is used to label any method of likewise enhancing profit and loss potential for investors. Those prospects are now offered by a very wide range of instruments, most of which fall under the umbrella of geared products (investments made with borrowed money), also known as “derivatives”. These instruments are generally defined as those that get their price from some underlying asset. As an example, the actual price of the equity is the underlying asset for stock futures, options, or CFDs.
Here is an example to illustrate the concept using a fake company:
The numbers we will be working with are as follows:
Entry @ €27.34
Exit @ €28.85
Profit = €1.51
The key element is to focus on how leverage works in the context of CFDs.
If you had €5000 on deposit, the highest number of shares you would be able to buy is 182. The simple way to find this is to divide the €5000 balance by the price of a single share:
182 shares = €5000 / €27.34
If the trade was done using CFD leverage on the same €5000, a CFD investor could take a position corresponding to the ownership of at least 1828 shares.
Profit for share trader: €274.82
Profit for CFD trader: €2748
Remember that CFD leverage has its dangers as well. It is great to see a multiplication of your profits, but at the same time there is nothing good about multiplied losses. It is a CFD trader’s task to understand and manage this inceased risk. You have to be the regulator as well as the investor. Budgeting your cash is central to all successful online CFD trading, and the key to this type of money management when it comes to trading is to cap risk by using stop losses.
