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CFD trading uncovered: Understanding the risks of trading on margin

by , 19 June 2015

Trading contracts for difference (CFDs) has a number of benefits. One of these key benefits is the money multiplier effect at work because you trade on margin.

But it's this aspect of CFD trading that also makes them risky. If a trade doesn't work out, your losses can quickly mount up.

So how can the margin work against you when you trade CFDs?

Read on to find out…


The downside of trading on margin


Let’s take a look at how trading on margin can go against you with the help of an example…

Mark wants to buy 1,000 Company ABC shares, which are trading at 100c each. This gives him a total exposure of R10,000 (1,000 x 100c). Mark buys the shares outright and isn’t trading on margin.

His trade doesn’t work out as planned. A week later, shares in Company ABC drop 30% after the company releases a profit warning. This takes the share price down to 70c.

So Mark decides to cut his losses and sells his shares. He received R7,000 (10,000 x 70c). This means he lost R3,000 or 30% of his investment.


The impact of trading on margin on your losses


If Mark had decided to trade CFDs on Company ABC, his losses would be much greater as he’s trading on margin.

Let’s say Mark buys 1,000 CFDs on Company ABC when the share price is trading at 100c. This gives his the same total exposure of R10,000.

To open the trade, he has to put down a 10% margin or R1,000 (10% of R10,000).

When the share price drops to 70c a share, Mark exits his CFD trade. This gives him the same total exposure of R7,000, like above.

But the difference here is the losses. His losses are actually 300% because of the gearing aspect as Mark is trading on margin this time.

To work this out, you need to look at the difference between the opening and closing prices of the trade. This is R3,000 (R7,000 – R10,000). You divide this by your initial margin to calculate your percentage loss of 300% ((R3,000/R1,000) x 100).

This shows you the impact that trading on margin has on your losses. And illustrates how important it is to use strict stop losses to limit your potential losses from trading CFDs.

When trading on margin, it’s vital you don’t overcommit yourself in one trade. Only risk a small portion of your trading pot to each trade.

Only risk what you’re prepared to lose.

So there you have it. Understanding the risks of trading on margin.








CFD trading uncovered: Understanding the risks of trading on margin
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