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Factors to consider to help you to have the right leverage when trading in CFDs

in Finance on 16th July 2020

No doubt, contract for difference (CFDs) are increasingly becoming preferred trading instruments for many traders globally. This is because they need low capital to start trading, they are flexible regardless of the market environment, and they have leverage opportunities. 

When it comes to leverage opportunities, you can make profits from the slight percentage movements of financial instruments. However, these movements can also go against you, meaning you can make significant losses. For this reason, it’s important to understand leveraged trading. This post will discuss some of the factors to consider before you start trading to help you to have the right leverage in CFDs. 

How CFDs leverage trading works

CFDs leverage allows you to maximize the underlying instrument potential return. As a trader, you can borrow from brokers, especially if you desire to do larger trades. In this way, it gives you a chance to do a larger trade without using your own money alone. 

For example, you can open a margin account with a forex broker with leverage that is either 50:1 or 500:1. The amount of leverage usually depends on the size of the instruments and brokerage you’re trading in and your risk profile. 

That said, forex trading can have average trading of $100,000 of the quoted currency. Hence, if you decide to go with 50:1 leverage, it means your account should have at least 2% of cash which is the total value of available trade. 

Here is the deal, if you choose to trade $100,000 of the quoted currency in a CFD agreement, you can deposit only $2,000. This amount will ensure that you open and maintain an account, rather than depositing the full $100,000. 

Pips are used to measure movements in forex prices. So for any pip movement, there are 10 units change in the normal lot. If you have $10,000 cash in your account and decide to go for 50:1 leverage, you can opt for positions that are worth $500,000. 

In forex trading, this translates to 5 standard lots. Now, every pip movement will cost you $50. Ideally, if the underlying instrument moves up by 50 pips, you can get $50 x 50 pips to make it $2,500. Etoro Review highlights the best amount of leverage that can maximize your gains.  

But if the market goes down against you, it means your loss will also be $2,500. This is 25% of the whole trading account that has $10,000. As you can see leverage can sometimes benefit or work against you. Keep in mind that in CFDs trading, the gains and losses are determined by the full contract value when the trade closes. 

Hence, if the price moves in the wrong direction, you stand a chance of losing the entire trading account. In such cases, you need to deposit extra funds to maintain your margin account so that you can trade. You can choose to deposit extra funds as required or close the positions to minimize the exposure. 

The right amount of leverage

Leveraging can make CFDs trading more efficient than most of the other types of trading. Like any trading types, there are also pros and cons with leveraging. The best thing is that it allows you to optimize your returns and can help you to produce significant returns. 

However, there are also some risks while using highly leveraged instruments. Therefore, below are some factors to consider to make sure that you have the right amount of leverage:

Find a regulated broker

One of the solutions to having the right leverage is to choose the best CFD broker. Price is one of the things that can affect your returns. Therefore, choose a CFD broker that provides good spreads and is neutral in the market. 

Aside from this, the broker should offer an intuitive and robust platform for easy trade activities. Mind you, a regulated broker can avoid giving you irresponsible leverage amounts, such as 1,000:1. After all, regulatory institutions like FCA restrict the amount of leverage that certified brokers offer to their traders. In this way, your interests are always safe with such brokers. 

Trading strategy

Any type of trading requires a good strategy. Therefore, you should first find out the best strategy that you want to adopt to trade CFDs. If you would like to use small price changes of the underlying instrument to make significant gains, then higher leverage is needed to generate large returns. 

On the other hand, if you want to adopt a trend following strategy, you can track larger movements, though they can take time. In such situations, you should use lower leverage. 

Risk-reward profile

It can be overwhelming for beginners to make sense of the CFDs trading. So the best way to start trading is to take a conservative risk profile. This involves taking leverage amounts that are lower, such as those ranging from 5:1 to 50:1. But experienced traders can use higher leverage because they tend to have higher risk tolerance. 

Besides the entry price, trades have an amount that you put into them, allowing you to have an idea of how much money you can lose. With forex and CFDs, you can give mini-lots and micro-lots, and make sure that you have a smaller position size than the standard lot. Therefore, if you’re not happy with the amount of leverage provided, you can always choose to reduce the position size. 

Also, you should have a set limit on the amount that you are prepared to lose, which can be 1% to 2% of your overall trading capital. Then you can calculate backward to determine the exact amount you need to put into CFDs trading to minimize losses and choose the leverage accordingly. 

The behavior of the underlying instrument 

The forex markets are known to have lower historical volatility than the markets for equities, commodities, and indices. However, most traders find forex markets to be extremely liquid. Therefore, forex and CFDs usually come with options to provide higher leverage. 

On the other hand, indices and shares have lower liquidity and higher price volatility. Because of this, you need to go for a lower leverage to protect positions from the significant price changes.  

Risk management

Your positions should have stop-losses settings at the right levels to prevent losses when a trade moves in an unfavorable direction. Human errors while trading can also be removed through these orders. 

But if there are no stop-loss settings due to certain market requirements, you can still use trailing stops that can close the positions at a specific price level.

Categories: Finance

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