How does CFD leverage work?

CFDs, or contract for differences, have become increasingly popular amongst traders, with a 2021 Trading Authority survey showing that nearly 560,000 people traded CFDs each month in 2020 – an increase of 32% on 2019.

According to Investopedia, this booming type of trade sees a buyer and seller enter a contract whereby the buyer must pay the seller the difference in value between an asset’s current value and its value at a time stipulated in the contract. This way, CFDs let people speculate on the movements of stocks, shares, and other assets without actually owning them. 

But before you head off and get involved in CFD trading, it’s crucial you understand one of its main features: leverage. In this guide, we explore what CFD leverage is and how it works, before exploring the pros and cons.

What is CFD leverage? How does it work?

CFDs offer traders the ability to expose themselves to the market for much more than the capital deposited. Known as margin trading, a trader might put down just 10% of the total cost of the stock they wish to speculate on, leveraging their investment ten times. 

If the CFD ends up working in the seller’s fortune, then they will make as much money as if they had put down ten times as much capital as they did. This way, the trader can leverage their capital across many more investments that otherwise would be possible. 

However, if the seller is incorrect, they will be liable to pay ten times more than they invested, which makes CFDs extremely risky trades.

The pros of CFDs

There are several benefits to trading CFDs:

• Greater leverage – As noted above, CFDs let traders invest far more than the capital they have to hand, freeing up their cash to work across more investments, and potentially earning them higher returns.

• Many investment opportunities – CFDs do not involve owning the actual asset, which means traders can invest in a huge variety of trades across practically every market worldwide.

• Anyone can day trade – In many markets, day traders must have a certain amount of capital to access the market and invest. CFDs do not come with these limits, allowing anyone to trade.

The cons of CFD leverage

Of course, there are also several negatives that anyone who wants to trade CFDs should be aware of:

• Higher exposure – If the call is incorrect, then the trader will have to pay their losses. These can be curtailed with stop-loss limits, but these don’t remove the underlying risk.
• Paying the spread – Some CFDs require investors to pay a fee (the spread) whenever they enter or exit the contract. This means that small, less risky trades are often unviable, as the cost of the spread would outweigh any potential gains.

CFD trading is taking the investment world by storm, but it’s crucial you make sure you’re completely in the know before you put your money on the line. Hopefully, with the tips and information above, you should be able to make well-informed trades.