We have touched on how CFDs work and the basic differences between shares and CFDs, now it’s time to explore the specific characteristics of CFDs in more detail.

Common Terms

CFDs and trading itself, has a unique language that you may find new.  If there is a term that you aren’t familiar with, check out our glossary (the book icon in the menu below) for a brief explanation.

Margins & Leverage
Margins and leverage are terms that are sometimes used interchangeably, but it is important to distinguish between them:

Margin: is the amount of deposit required to secure a position.
Leverage: is the ability to take a position with notional value greater than the cash outlay required.
Let’s look at margin and leverage in more detail.

Margin

Margin is the amount of deposit required to secure a position.  Margins are:

  • between 1% to 50% depending on the nature of the underlying product.
  • calculated as a percentage of the notional value of the position
  • held in reserve in the traders account so that the CFD provider is covered if a position moves against a trader
  • returned to the traders account when the position is closed out
  • at the discretion of the CFD provider and may be increased at any time for any reason (e.g. as result of the suspension of trading of the underlying product
  • determined by a range of factors including the liquidity of the underlying product and its capitalisation

Leverage

Leverage is the ability to take a position with notional value greater than the cash outlay required. Leverage is often known as gearing.  Investors use leverage when they borrow money from a bank to invest in an investment property.  You can also borrow money to buy shares and this form of leverage is mostly done through taking out a margin loan.

Traditional share holding has a leverage of 1:1.  That is, for every $1 of investment the trader is required to pay $1 in cash.
You can also borrow money to buy shares and this form of leverage is often done through taking out a margin loan.  Trading CFDs is similar to taking a margin loan because when you trade a CFD you are only paying small portion or percentage of the whole amount upfront and the rest of the amount is loaned to you by the CFD provider.
A CFD position with a 5% margin has a lever of 1:20.  That means for every $1 of cash invested the profit or loss will be multiplied by a factor of 20.
For many investors and traders, being able to trade on margin (using leverage) is the biggest attraction of CFDs because it increase the opportunity to make profit using a small amount of capital.  However, trading on margin can be a two-edged sword:

Leverage has the effect of magnifying a trader’s profits and losses.

When used wisely and appropriately using leverage can be a big boost to profitability and capital building.

 
Download our Margin & Leverage Ready Reckoner (Click here to open document)  and consider the questions we pose to help you understand how to use leverage appropriately.