What Is Leverage And How Is It Used In Trade?
A key feature of CFD trading is leverage, a powerful tool that also goes by the English name leverage.
Leverage offers traders to take advantage of relatively small price changes, greater flexibility and extend your exposure. It is therefore hardly surprising that the leverage and its effect have made CFD trading so popular.
Simply put, leverage is the tool with which your initial investment in a CFD gets more significant exposure in the same asset. The result is a leverage effect, which implies that CFDs increase the potential profit.
Let’s take a look at an example to concretize the leverage in CFD trading for an underlying asset where the collateral requirement/margin is 5%.In other words, traders are required to invest a minimum of 5% of the amount they wish to trade with.
We are going to examine what the corresponding trade would look like if an ordinary broker executed it.
Ordinary stock trading with the stock ZX
You want to buy 1000 shares in the company ZX which costs 250 USD. Your total investment is, therefore, USD 250,000, i.e. USD 250 x 1,000 shares.
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CFD trading with the share ZX
If you instead choose to trade CFDs for the same share, it would be equivalent to you buying 1000 CFD contracts for the same company stock in the belief that the value will rise. But the advantage of CFDs is that you can use leverage to get the same exposure but with a smaller investment. In this case, it is a 5% security requirement or margin, which is equivalent to USD 12,500 that you need to invest for you to be able to trade with 1000 CFDs for the stock ZX.
The calculation is as follows:
USD 250 per CFD for share ZX = 1000 x 250 = USD 250,000
5% of USD 250,000 = USD 12,500
This means that if you choose to purchase CFDs for ZX, an investment of USD 12,500 is enough to buy 1000 contracts. Compare this with buying the share from an ordinary stockbroker and then having to invest as much as USD 250,000 to be able to buy the same number of the same share.
We hope our leverage article has given you the information you need. The next natural step is to check in with one of the CFD brokers we can recommend to take part in some of their training materials to read more about how to trade with leverage: