The Power of Leverage with CFDs

If not for leverage, the potential returns from trading would be pretty modest, not unlike what investors shoot for. Investors look for long term increases in price, looking to take advantage of things like the stock market averaging about a 10% gain per year. These trades, or investments if you prefer, are generally not leveraged, and the stock or the funds are bought with cash and provide linear returns of 1:1.

Trading look to beat these returns overall, which involves things like looking to time investments more, being in more when the price is rising and being out more when it is not, or even better, being on the right side of these down movements.

A skilled trader can outperform the market this way pretty easily and pretty significantly, in terms of this linear return, and the potential to do this is what attracts so many people to trading. Rather than just letting their investments ride whatever waves come, up and down, traders are more like surfers, looking to ride these waves and capitalize a lot more on them.

The Power of Leverage with CFDsThe second tool that traders use is taking advantage of the power of compounding, where the profits that are realized are reinvested over time. This can be quite a bit more powerful than many people think compared to fixed investing which just captures the simple return.

If both a trader and an investor realized a 12% gain on something over a period of 10 years, at the end of the 10 years, the investor would have realized a nice 120% gain. In other words, if they had invested $10,000, they would be left with a total of $22,000.

A trader, on the other hand, could continually reinvest their profits over this time, and once one becomes proficient enough, it certainly makes sense to do so. The trader could be trading the same stock as the investor with the same simple return rate but could realize bigger gains from all the reinvestment they could do.

In our example, with a 1% average monthly return, and turning over their portfolios several times and often many times every month, this will allow a much greater return over this time, because in each subsequent month the 1% return will be applied to greater and greater amounts of principal, instead of just to the fixed principal amount that the investor uses. In this case, the extra compounding would yield a total of $33,333 to the trader, who would have made roughly twice as much money than the investor over this time.

Given that traders shoot for considerably higher annual returns than investors do, from their ability to time their trades, this compounding really can kick in and make a big difference.

How Leverage Affects All This

The biggest difference maker here is neither of these, or even both put together. Leverage can accelerate returns like nothing else, depending on how much is used. Even with the more modest amount of leverage that some professional traders use of 10:1, this alone produces a return 10 times greater than a simple return.

Now, instead of just realizing the 12% average return that we just spoke about, this will launch this return to 120%. If someone wants to use 30:1 leverage, similar to what futures traders use, we’re now talking 320% from the same 12% move.

If you compound that, even using just an annual compounding would mean that one could increase one’s portfolio roughly 5 fold per year. There are of course practical limitations to this, as once one’s account grows into the millions, trade sizes start becoming large enough that they move markets, and ultimately one may get to the point where positions cannot be entered and exited at the same time.

Some CFD brokers offer leverage as high as 1000:1, but this is not just a matter of choosing to accelerate one’s returns a thousandfold over cash, as there is a downside to leverage.

This much leverage would actually be suicidal, because while you could increase the value of your portfolio many times over in a matter of minutes, even a very small movement against you would wipe it out. By keeping the stakes this high, you soon would meet this fate no matter how good of a trader you are.

Leverage does not just amplify potential gains, it also amplifies potential losses. While we do want to amplify our gains, we must do so with a measure of safety, and this is why proficient traders will only use sensible amounts of leverage, in the range of 10:1 to 30:1 typically.

The more leverage you use, the more control you need to use, and the 30:1 for instance is only suitable to be used with tight stops, such that a move against you will not result in a loss of more than a percent or two of your portfolio.

You can’t really do that effectively and stay in positions very long on average, so this level is pretty much limited to day trading only, and preferably shorter term day trading. As one needs or wishes to give their trades more room, less leverage must be used, lest one constantly get stopped out from meaningless movements, which is a recipe for disaster in itself.

The goal instead needs to be to match the amount of leverage with the amount of room that your trade requires for it to be deemed moving the wrong way according to your strategy. The longer the term and the more profit that is sought from a trade, the more room it will require.

Choosing the Amount of Leverage with CFD Trading

Some new traders may think that if a CFD broker provides a certain amount of leverage, that’s what you’ll be using, and might not even be scared away from the higher amounts that some may offer, like 500:1 or 1000:1.

How much leverage you can use is actually going to depend on your country’s regulations, and in some countries they only allow much more modest amounts, like 20-33:1, and with some instruments like shares, only 5:1 or even less.

The reason why regulators do this is to seek to protect their traders, and these sky high leverage amounts aren’t suitable for anyone actually, even with the best professional traders. No matter how good you are, the risk of drawdown is simply going to be way too high with 500:1 or even 100:1.

At 100:1, a 1% move against you in the asset will wipe you out, and your broker will close your trade even before this, due to a margin call. CFD brokers don’t mess around here, they don’t give you days to deposit more like they might with a small amount of leverage with a stock with clients who they believe are good for it. There’s too much at stake here where a trader may lose several times their investment if they aren’t careful.

While it is an absolute necessity to use stop orders with CFDs, all instruments have gaps, and stop orders can’t protect you against them. If your trade gaps against you big, and you are using even a modest amount of leverage, you will be in a world of trouble, and not only lose all the money in your account, but owe your broker a lot more than that.

Some CFD brokers offer guaranteed stops which can help against this, but the pricing of these is on the expensive side, you’re paying for this risk with each trade, and this is not something professional traders would generally consider ever doing.

The only real way to protect against gaps is to not be in the trade when the market for it is closed, which is at the end of the trading day for some assets and the end of the trading week for others, those that trade 24/5.

If the market is open, a stop loss order may end up costing you extra in slippage but the order is at least live. Since the CFD broker provides both the trade and the market, stop losses are generally safer with CFD brokers than they are with external trades.

So while margin is certainly a powerful tool to accelerate returns, it needs to be used safely at all times, and the saying safety first does indeed apply here. There is no room for big mistakes here, and the more leverage you use, the bigger the impact of mistakes.

One can easily decide how much leverage they will use, by simply only committing a portion of their account to trades, and keeping the rest in cash. So with some very simple math you can select 2:1 or 20:1 or whatever amount you want, even if your broker automatically applies the maximum.

Making Sure You Are Leveraging Advantages

If you have a trading advantage, leverage will amplify it, and all you have to worry about is drawdown risk. In this case, although your trading plan may win overall, it will always undergo a losing streak, and you want to make sure that these losing streaks don’t impact your account balance too much.

On the other hand, if you have a trading disadvantage, leverage will just amplify that, and you never want to be amplifying disadvantages. This simply means that you will go broke faster or a lot faster, and going broke cannot be something we ever want to speed up.

On the contrary, traders who do not have a trading advantage yet, one that they are at least comfortably confident with, should never be using leverage and in fact should only be trading a small portion of their account at any one time.

The goal here isn’t leverage, it’s de-leverage, where trade sizes are kept small enough that they will not put the hurt on you as the inevitable probably happens and you suffer net losses with your trading.

The extreme of this is trading with a simulated account, and one should not even be trading with real money, even de-leveraged, until one at least shows that they will probably be profitable. This involves a lot more than taking the software for a spin and figuring out how to enter trades like some brokerages want you to use this for.

If a trader is losing money with a simulated account, it does not make the least bit of sense to prefer the money lost be real money, unless one is made happier by losing money. Once you can make fake money, and only then, should you be moving on to the real thing, if you are wise that is.

The ability to use a good amount of leverage, 30:1 for example, and turn the comparatively pedestrian returns that investors shoot for into some potentially huge ones, three figure returns, is an exciting prospect indeed. There’s much more to this than just opening an account and hitting the ground running, and while many new traders have some lofty ambitions, there is no substitute for being both realistic and patient.

Leverage can vault our trading to great heights, and can also crash it on the rocks, and far more accounts are sunk with it than vaulted. In the right hands, the kind of leverage that CFDs allow for can be an incredibly powerful tool, but only when you are ready.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: andrew@marketreview.com

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