CFD mistakes: Misuse of leverage

Even the most seasoned professionals have been known to accidentally buy instead of sell or trade the wrong quantity or even the wrong security from time to time. These mistakes can generally be  voided by exercising the appropriate level of care. Most other mistakes are the result of either a lack of preparation, knowledge or discipline on the part of the trader. Having the ability to avoid making these mistakes will improve your chances of developing into a successful trader.

While it is wise to learn from your mistakes, it is even better (and considerably less expensive) to learn from the mistakes of others. By outlining some of the most common mistakes made by CFD traders, we hope that you will be able to avoid making the same mistakes.

Misuse of leverage

One of the major advantages of CFD trading is the ability to trade on margin. Instead of outlaying the full face-value of a transaction, CFDs allow a trader to take the same position with an outlay of just 10%, 5%, or even less of the face-value. Despite a smaller commitment of capital, the trader still acquires exposure to the impact of price swings for and against the full face-value of the trade. This gives CFD traders a greater exposure than can be achieved by trading, for example, traditional, non-leveraged securities.

One of the major advangtages of CFD trading is the ability to trade on margin.

A CFD trader trading on a margin of 10% can effectively leverage their trading funds by a factor of 10. If trading products on a margin of 5%, leverage of 20 times is available. This would mean that a trader with a $10,000 trading account could be controlling positions with a face-value of $200,000, or even more if lower margin rates are available. This is shown in the table below.

Account Value Margin Leverage Factor Maximum Exposure
$10,000 5% 20:1 $200,000
$10,000 10% 10:1 $100,000
$10,000 20% 5:1 $50,000
$10,000 50% 2:1 $20,000

Many CFD traders look only at the extra buying power that leverage makes available to them. They make the mistake of ignoring the fact that leverage is a double-edged sword. Despite only outlaying a fraction of the face-value of a trade, the CFD traders account balance will move up or down based on the full face-value of the position. This is fine if prices move in the anticipated direction. If trading a CFD where the underlying asset is a security on a margin of 5%, a price rise of 1% in the underlying security could deliver gains against the CFD position but it could also result in a loss of 20%. If CFD traders  overlook this feature of trading on margin, they risk making the mistake of taking on too much risk.

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