Understanding CFD Margin

If the broker lends you money for trades, there should be collateral to cover the risks you put the broker in. Therefore, you must make some initial deposit to the CFD account before entering a leveraged position. This deposit is known as the margin.

In other words, the margin is the minimum amount you should have in your account to trade CFDs. Suppose you want to enter a CFD position that is worth $30000. If the trade requires a 3% margin, you must put down $1000 to enter the trade. In volatile markets, the margin percentage tends to be higher.

To keep your position open, your total balance in the CFD account can never fall below the margin. This can cause great stress for the investor when their assets perform opposite to their predictions.

For instance, you had put $1000 in your account to open a long position worth $30000. Suppose the price of the assets starts falling, and your position comes to -$100. This means your margin has been reduced to $900.

To the broker, the reduction in margin means you will not be able to compensate for the losses when your position closes. So, they would notify you with a “Margin Call.” They tell you to replenish your account to bring it up to $1000. A maintenance margin might be higher than the initial deposit in some arrangements.

If you fail to respond to the margin call and bring up your margin to their requirement, the broker will close the trade before the set point. This means you will suffer significant losses.

How Leverage Magnifies Profits and Loss in CFD Trading

CFD trading with leverage is popular among short-term investors because it can easily magnify small capital to huge profits. However, the same mechanism can work against the trader and cause them overwhelming losses. It’s easier to understand with an example.

Suppose company X’s shares are priced at $30. Therefore, a position that holds 100 shares of the company would be $3000. As a trader, you have two options for gaining this position. Firstly, you can traditionally buy the shares. In that case, you must deposit $3000 to your broker account.

On the other hand, you can enter the same $3000 position via CFDs. At a common 10% margin requirement, you will only put down $300 to enter the position. You will leverage the remaining $2700 from the broker.

If X company performs well during that trading session, its share price might rise to $32. When it closes, the $3000 position you entered will be worth $3200. Consequently, you made a profit of $200.

As such, the CFD trader has made a 66% profit against the initial investment. Meanwhile, the traditional investor has made only a 6% profit. However, both held a position of the same value. This is how CFD leverage can magnify your profits.

Similarly, if company X performed contrary to your predictions, you would lose $200. This means the CFD trader suffers from a disastrous 66% loss, leaving him with only $100 (or less due to the deduction of fees and costs). Meanwhile, the traditional investor only faced a 6% loss. That’s how CFD leverage can magnify your losses.

How To Minimize CFD Trading Risks?

As you can see, CFD trading comes with the promise of unbelievable profits and crippling losses. That makes CFD trading sound almost like gambling – but it’s not. Unlike gambling, CFD trading is more scientific and rational. However, you must have the proper education, plan, and strategy to make it that way. Here are some helpful tips to minimize risks in CFD trading.

Have a Trading Plan

You can’t be a professional CFD trader if you don’t have a trading plan. You might have sporadic success out of sheer luck. But you will suffer losses when you least suspect it and instantly see all your capital disappear. Building a trading plan will provide you with small but steady and consistent gains. Plus, you will not frequently suffer losses.

To build a good plan, allocate the number of daily hours you will invest in CFD. You can further divide this time between gaining education and actual trading activity. You should also set realistic trading goals.

Furthermore, be wise with your capital. You don’t want to put everything on the table. That’s true even when you are on a hot streak.

Your trading plan must also include choosing markets and brokers carefully. You should only CFD trade the underlying assets you have adequate understanding and knowledge about. If you want to trade a wide range of assets, educate yourself about them first. Lastly, maintain a journal to track and record your trading activities.

Be True To One Method

One of the major reasons why CFD traders suffer overwhelming losses and go broke is acting out of emotion. The market is always volatile. Plus, it is ridden with rumors and bad advice. A trader can easily give in to the fear or greed of their peers and trade in a way they don’t clearly understand. The consequence of which is usually a disaster.

A strict trading strategy can save you from this. Various CFD trading strategies include scalping, high-frequency trading, hedging, position trading, etc. You should adopt a trading strategy early in your career and stick to it through thick and thin.

Adhering strictly to a strategy will help you find stability in the volatile market. It will also keep you from acting out of emotion. Because when you see that a trading activity doesn’t comply with the strategy you follow, you can avoid participating in it.

It’s also important to review your methods from time to time. Your journal will help you evaluate how well the strategies are working for you. Following proper education and demo practice, you can switch to a better method if you wish to.

Evaluate Your Position

CFDs let you enter a powerful and highly valuable position cheaply. These big positions allure many traders with their promise of immense returns. However, many traders also forget that entering a big position exposes you to serious capital losses.

Therefore, it is essential that you only enter positions where you can afford the losses. Investing a small percentage of their capital in CFDs is the ideal course for beginners. Also, avoid trades that require higher margins because your losses will be too great if your predictions fail.

Apply Stops and Limits

A stop-loss order is an effective way to minimize risks in CFD trading. It essentially means instructing your broker to sell a security if the price comes to a pre-defined level. That way, even if the market moves against your position, your suffered losses shall keep to a minimum.

Suppose you bought a CFD on a stock at $200. You then put a stop-loss order on it at $150. If the market moves in the opposite direction, your broker will automatically sell the position when the price falls to $150. That way, you ensure that your losses in this trade are at most $50.

Do Your Market Analyses

77% of CFD traders lose their money in the market. So, what separates a winning trader from the rest? Well, they can analyze the market better than others.

Traders analyze markets in two ways. The first one is technical analysis. Here, you review the movement of past prices, volumes, chart patterns, and other technical data to identify trends in the market. This helps you make informed and scientific predictions and increase your chances of success.

Besides technical analyses, professional CFD traders also keep up to date on current events. Wars, announcements, pandemics, rumors, and news flashes drive public sentiment and affect the market. The experienced trader can understand the implications of these events and trade accordingly.

Conclusion

CFD trading can be highly profitable if you know what you are doing. But getting to that level of expertise takes time. So, as a beginner, you should start with smaller capital.

Instead of quick money, aim for successful trades and develop a deeper understanding of the market. Our educational materials and vibrant forums can assist you in this journey.

About the author – D. Schmidt

I’m a German stock trader who has lived around the world. I travel extensively and believe that my experiences give me a unique perspective on global markets. I love trading! It’s always exciting to see what happens next. My goal is to help people understand the game so they too can enjoy it to the fullest. In this blog, I will share some tips and tricks that helped me along the way.