The forex and CFD markets provide traders with an opportunity to take advantage of borrowed capital. Just like a mortgage, where you can purchase your home using borrowed capital from a bank, you can employ the same techniques with CFDs.
Your broker uses a margin calculation to determine how much money you need to have in your account to allow you to borrow to trade and will constantly update their calculation in real time. There are several benefits of using borrowed money to trade including the ability to enhance your returns.
What is Leverage
Leverage is the ability to borrow money to trade forex or CFDs. It is also available in futures trading, options trading and equity trading. The issue for a broker is whether you have enough capital in your account to cover losses you might incur. The way your broker determines this is through a margin calculation.
What is Margin
A margin account is an account that allows you to borrow capital to trade a specific market. When you are offered a margin account, it is because your broker believes they can lend money to you which will incent you to trade. The capital you have in your account is referred to as equity. As your equity grows, the amount of margin you can use increases.
Depending on the products you trade, your margin can increase up to 400 to 1. Your broker will update your profit and loss in real-time and determine whether you have enough capital in your account to cover the loss. The more volatile the asset, the lower the leverage.
If the equity in your account drops below a level where your broker believes your equity will not be able to cover your losses, they will initiate a margin call.
Each broker has a different calculation. If you receive a margin call, you will need to increase your capital immediately. If you don’t your broker reserves the right to immediately close your position to avoid additional losses. Your broker will never accept losses in your behalf.
Leverage is a double-edged sword. Not only will it enhance your returns, but it can also accentuate your losses. For example, with $100 dollars, you can control a position of $2,000 EUR/USD with the leverage of 20 to 1.
A five percent move on the currency pair, with allow you to double your money ($2,000 * 5% = $100). In addition to doubling your gains, you can also wipe out your capital.
There are significant benefits to using leverage. The borrowing costs are very low, allowing you to significantly enhance your returns. You want to make sure you use leverage in a prudent fashion as it cuts both ways and will also enhance your losses.
By using leverage, you can allocate your capital to multiple securities, as opposed to putting all your eggs in one basket. By controlling more capital with leverage, you can generate a diversified portfolio of CFDs.