The ability to use leverage is one of the biggest benefits of investing in CFDs. With a relatively small investment, you have the potential to reap much larger profits. Some inexperienced traders focus on this upside potential, ignoring or discounting the fact that leverage can also lead to magnified losses if a trade doesn't go your way. Smart investing requires a thorough understanding of how both the risks and rewards of your investment work.
The Basics of Leverage
A situation that is often used to explain leverage is buying a house. Say you want to buy a house that costs $300,000. With no leverage, you would have to pay the full $300,000 to purchase it. If you only put down a 10 percent down payment, or $30,000 cash up front, then you are using leverage to buy the house. Your outlay is only a small percentage, but you now have use of the whole house.
How Leverage Works with CFDs
When you want to trade CFDs (Contracts for Difference), leverage works in a similar way. Say you think the price of Google stock is going to rise. In a traditional stock investment, you could purchase 100 shares at $500/share, for a total investment of $50,000. If you want to do this as a CFD trade instead, you could put down just 10% of that price. You would invest just $5,000, but would get the same exposure to Google stock.
On the positive side, say you're right and the price of Google goes up to $525/share. If you'd made the full $50,000 investment, then your $2,500 profit would be a return on investment (ROI) of 5%. If you did this as a CFD with 10% margin, then the same $2,500 profit would give you an ROI of 50% on your $5,000 investment, a much greater return.
Unfortunately, the negative side of this is that risks are also magnified by leverage. If the price went down to $475, then a full $50,000 investment would lose $2,500, or 5%. You'd still have $47,500 (95%) of your investment funds intact. With the leveraged CFD investment, your $2,500 loss would be 50% of your investment, so you would lose half of your capital.
What Happens as You Increase Leverage
Increasing leverage magnifies your risks and rewards even more. If you only invest 5% on the CFD, the same $25 price swing on Google would give you either 100% profit or 100% loss (wiping out your investment entirely).
If you further increased leverage by only putting down 2% on a CFD, then the same price swing would give you either a 250% profit or a 250% loss, meaning you could lose much more than you invested. This downside risk is why it's critical to use a stop loss when making CFD trades.
Leverage is appealing because it can lead to very attractive profits, but you need to be smart about managing it. Compare CFD brokers when you're getting started, since the maximum leverage they allow can vary.
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