Trading with leverage, or margin, introduces a rather unwanted friend to the trading table, commonly referred to as a margin call. The problem with highly leveraged CFDs – in contrast to using a margin loan to buy shares – is that margin calls are typically more frequent when trading CFDs. Small moves in the price of a CFD can mercilessly fling a trader into margin call territory.
For those unfamiliar with how a margin call works, a simple example follows. Let’s assume that you have $10,000 in your account and you decide to leverage the full amount ten times to buy $100,000 CFDs priced at $1.00. For simplicity we are excluding brokerage and interest costs on the CFD trade.
If the CFD falls to $0.99 your exposure correspondingly falls by $1,000 to $99,000. To maintain a 10 per cent margin at least $9,900 is required in your account. So having lost $1,000, your account balance of $9,000 is short of funds.
A pop-up will appear on your trading screen with an alert indicating that a margin call is due. Most CFD provides will give you 24 hours, or two days on request, to close the position, add $900 to the account, or reduce your exposure to the stock.
If the stock continued to fall to $0.95 and you didn’t respond to the margin call, most CFD providers will automatically close the position out – wiping $5,000 from your account and leaving you with $5,000 remaining.
As you can see from this example, it only takes a small move in the price of a CFD for you to be hit with a margin call or be closed out of your position altogether. Because of the lower leverage used, traders who use margin lending to trade shares will have more room to move. For instance, a $10,000 deposit could be combined with a $23,000 margin loan to buy $33,000 worth of shares priced at $1.00 (using a maximum loan to value ratio of 70 per cent). In this example, a margin call would not occur on a trader’s account until the shares hit $0.93, rather than $0.99 cents in our CFD trading example (most margin lenders allow a 5 per cent buffer before a margin call kicks in). Of course, the lesson here is that the higher the leverage employed the more likely it is that you’ll face a margin call on a trade.
Another way to sidestep outflows from your account is to restrict the amount you risk on any one trade. Some recommend risking no more than 3 to 10 per cent of your account on a single trade – which is clearly more viable for someone with $50,000 in an account than just $5,000. It thereby supports that argument that you need at least $10,000 in cash to legitimately start trading CFDs.
The final and most vital step in minimising losses on CFDs is always employing a stop loss and most importantly, knowing where to place it on a given trade.