Benefits and risks of leverage
Trading on margin means you can gain the same amount of market exposure by depositing just a small fraction of the total value of your trade. This leverage can be useful to CFD traders because it means that they can put their money to use elsewhere.
Leverage can help magnify your returns which is great news if the market moves in the direction that you expect. However, the key risk with leverage is that it can magnify your losses in exactly the same way as your gains.
There is the potential to lose part and more of your investment if you do not manage your risk efficiently. Losses can exceed your deposits and you may lose more than you initially invest.
For instance, say the margin requirement for a particular market is 5%. This means you would be required to deposit 5% of the full value of the trade as initial margin to open the position.
Share trading vs CFDs using leverage
You want to buy 1,000 shares in company XYZ and the current share price is $2.50. Your total investment is $2,500. The equivalent as a CFD trade would be to go long (buy) 1000 CFDs in company XYZ.
This example shows that with CFD trading you are only required to deposit $125 to open the equivalent of a $2,500 investment. This is how trading on margin leverages your position, freeing up additional funds to use on other products or other positions.
How leverage can magnify profits
Company XYZ share price rallies after strong earnings and you decide to close your trade out with a profit of $100. The return on your CFD deposit is 80%, whereas the return on your share trade is 4%.
How leverage can magnify losses
Supposing your trade in Company XYZ was unsuccessful and your stop loss was hit, the trade made a $100 loss. In this scenario, the return on your CFD deposit is -80%, whereas the return on your share trade was-4%. Using leverage has magnified your losses.
Please note margin factors vary across markets. Generally speaking, the higher the margin requirement, the riskier or more illiquid the market. Please see the relevant Market Information sheet on the trading platform for full details.
Margin calls and close out levels
In addition to margin, you should always ensure you have sufficient funds in your account to cover any losses for the period that you decide to hold open you trade.
If you don't, you could quickly find yourself on a margin call, which can happen when you don't have enough funds in your account to keep open the position which puts you at risk of having it automatically closed out. City Index closes out positions after funds have dropped below 50% of the trade's margin requirement.
You should always ensure you have sufficient funds in your account to cover any losses for the period that you decide to hold open your trade.
The Margin Level Indicator on the City Index platform represents the level of funds you have associated with your open positions. It is located in the upper right corner of the trading platform. It displays one of the three scenarios listed below:
If your margin level indicator is greater than 200%, this will show as > 200%. This means that you have sufficient funds required to keep your positions open
Your trade is at risk
If your margin level falls below 200%, the margin level will display a percentage between 50% and 200%. You are at risk of your trade falling further and automatically being closed out
Should your margin level fall below 50%, you no longer have enough funds in your account to cover your total margin. A warning symbol will be displayed next to the margin level if it drops below 80%. Consequently closure of your open positions may be triggered
What should you do if you are on margin call?
If you are on margin call, you have three potential options:
- Close out your trade
- Reduce the size of your position to free up some equity in your account
- Add additional funds to your account to cover the short fall in margin plus additional funds to sustain any further losses