The cornerstone of successful CFD trading is the understanding of what leverage is and how it can be used to drive profitability levels. Therefore, let’s open this discussion by taking an in-depth look at leverage and then how to utilize leverage while trading on CFDs to maximize trading profitability.
Succinctly stated, this article aims to answer the following questions:
Why is it vital to have a comprehensive understanding of what leverage is and how it is used when CFD trading?
By way of a simple answer to these questions, Warren Buffet, also known as The Oracle of Omaha, noted that, “When you combine ignorance and leverage, you get some pretty interesting results.” Furthermore, it is equally important to note that the Jones Mutual financial analysts fully endorse this answer to the questions asked above.
Leverage: What, Why, and How?
At the outset of this text, it is vital to be cognizant of the fact that trading CFDs using leverage is a high-risk activity, and investors should not invest money they cannot afford to lose. Noting this fact, however, does not mean that traders should not utilize the CFD-trading instrument as a profit-generating investment vehicle. Moreover, before trading on leverage, it is vital to do due diligence on an asset to ensure trading success.
According to investinganswers.com, leverage is an umbrella term that includes any technique that increases trading profits or losses. It is usually used to “describe the use of borrowed money to magnify profit potential (financial leverage).”
Furthermore, margin and leverage work hand in hand with each other. Succinctly stated, margin is the amount of money that is deposited with the broker as collateral when opening a CFD trading position.
The best way to describe leverage and margin working together to drive trading profitability is to cite a small case study.
Let’s assume that you wish to trade on the EUR/USD buy position. For the sake of clarity, opening a buy position translates into selling USD to buy EUR. It must also be noted that the reason for opening a buy trade is that when you use the Relative Strength Indicator (RSI) and the Bollinger Bands in conjunction with each other, the EUR/USD price is rising, and you wish to profit from this price movement.
At what point during this trade do you utilize leverage and margin to increase trading profitably?
The price movement of foreign currency pairs, especially the major and minor currency pairs, does not move by much during a trading day. It is usually between 10 and 50 pips per day. For completeness sake, the pip is the fourth digit after the point in the currency pair price.
Let’s also assume that the EUR/USD price is currently 1 EUR to 1.5000 USD. Therefore, for every EUR that you buy, you need to pay $1.5000. Let’s assume the price of 1 EUR increases to 1.5001. It has moved by 1 pip.
To trade without using leverage, you will need to deposit $150,000 USD into your trading account to buy 100,000 EUR. You then open a trade at 1:5000 and close the trade at 1:5001. Therefore, the value of your 100,000 EUR will be $150,010. In other words, the value of each pip on a 100,000 EUR is $10.
If you do not have $150,000 USD, then you need to use leverage and margin to derive the same trading benefits. Brokers will allow traders up to 400% leverage. In other words, if you trade on 200% leverage and your margin is $1000 USD, you can trade as though you have $200,000 in your trading account. Therefore, your trading profit will be much higher than if you trade without leverage.
Thus, it is clear how leverage can increase trading profitability in relation to the margin or trading deposit. There is a caveat, however: Leverage can also wipe out the investment account by the same percentage during a losing trade. Therefore, it is vital when trading on leverage and margin to implement risk-reducing trading strategies. After all, no one wants to lose their total investment in one losing trade.
Finally, it is for this reason that brokers state very clearly that you should only trade using funds that you can afford to lose.