Benefits and risks of leverage
Trading on margin means you can gain the same amount of market exposure by depositing just a small fraction of the total value of your trade. This leverage can be useful to CFD traders because it means that they can put their money to use elsewhere.
Leverage can help magnify your returns which is great news if the market moves in the direction that you expect. However, the key risk with leverage is that it can magnify your losses in exactly the same way as your gains.
There is the potential to lose part and more of your investment if you do not manage your risk efficiently. Losses can exceed your deposits and you may lose more than you initially invest.
For instance, say the margin requirement for a particular market is 10%. This means you would be required to have on deposit 10% of the full value of the trade as initial margin to open the position.
Share trading vs CFDs using leverage
You want to buy 1,000 shares in company XYZ and the current share price is $2.50. Your total investment is $2,500. The equivalent as a CFD trade would be to go long (buy) 1000 CFDs in company XYZ.
This example shows that with CFD trading you are only required to deposit $250 to open the equivalent of a $2,500 investment. This is how trading on margin leverages your position, freeing up additional funds to use on other products or other positions.
How leverage can magnify profits
Company XYZ share price rallies after strong earnings and you decide to close your trade out with a profit of $100. The return on your CFD deposit is 80%, whereas the return on your share trade is 4%.
How leverage can magnify losses
Supposing your trade in Company XYZ was unsuccessful and your stop loss was hit, the trade made a $100 loss. In this scenario, the return on your CFD deposit is -80%, whereas the return on your share trade was-4%. Using leverage has magnified your losses.
Please note margin factors vary across markets. Generally speaking, the higher the margin requirement, the riskier or more illiquid the market. Please see the relevant Market Information sheet on the trading platform for full details.
Margin calls and close out levels
In addition to margin, you should always ensure you have sufficient funds in your account to cover any losses for the period that you decide to hold open you trade.
If you don't, you could quickly find yourself on a margin call, which can happen when you don't have enough funds in your account to keep open the position which puts you at risk of having it automatically closed out. City Index closes out positions after funds have reached 80% and below of the trade's margin requirement.
You should always ensure you have sufficient funds in your account to cover any losses for the period that you decide to hold open your trade.
The Margin Level Indicator on the City Index platform represents the level of funds you have associated with your open positions. It is located in the upper right corner of the trading platform. The calculation for the margin indicator is determined by the Net Equity in your account divided by your Total Margin Requirement. To improve your margin indicator do one or more of the following:
- Deposit funds,
- Close or part close positions
What should you do if you are on margin call?
If you are on margin call, you have three potential options:
- Close out your trade
- Reduce the size of your position to free up some equity in your account
- Add additional funds to your account to cover the short fall in margin plus additional funds to sustain any further losses