When trading, it’s essential to make the most of your capital. By using contracts for difference (CFDs) and margins, you can increase your exposure to the market and potentially make more profits. This article will look at how CFDs and margins work and how you can use them to your advantage.
What are CFDs?
CFDs are a type of financial derivative that allows you to speculate on the price movement of an underlying asset without owning the asset itself. For example, if you think the price of gold will rise, you could open a CFD trade and buy gold contracts. If the price of gold does indeed rise, you’ll make a profit on your trade. Similarly, if the price falls, you’ll incur a loss.
How can you use CFDs to your advantage?
CFDs offer many advantages that can be useful for traders. Firstly, because you don’t have to own the asset physically, you can trade with a much smaller capital than you would need if you were buying the asset outright. The use of leverage can also allow you to control a more prominent position than your capital would normally allow, by magnifying your position size.
For example, let’s say you wanted to buy 10 ounces of gold outright. At the current $1,300 per ounce, this would cost you $13,000. However, with leverage, you might only need to put down $1,000 as a margin (the initial deposit required) to open the trade. When the market moves in your favour, you will take profits relative to your entire position size, magnifying your potential profits.
Yet, it’s important to remember that leverage is a double-edged sword – while the use of leverage can increase your profits, it can also increase your losses. It’s therefore essential to use stop-loss orders (which we’ll look at later) to limit your downside risk.
Another advantage of CFDs is that you can trade on the price movement of an asset without actually owning it. It can be helpful if you think an asset is overpriced and want to profit from a price fall. For example, if you thought the shares of company XYZ were overvalued at $100 per share, you could open a short position by selling XYZ CFDs. If the share price then fell to $90, you would make a profit on your trade.
CFDs also offer tax advantages in some countries. For example, in the UK, profits from CFD trading are exempt from the capital gains tax as traders speculate on the price movement of an asset instead of the asset itself. This means CFD traders can, in a sense, keep more of their profits.
What is margin?
When you open a CFD trade, you will only need to put down a small deposit – known as margin – to control a much more prominent position. It’s usually expressed as a percentage of the total value of the trade. So, if the margin requirement for gold is 5%, and you wanted to buy 10 ounces of gold worth $13,000, you would only need to put down $650 as a margin (5% of $13,000).
How does margin work?
The size of the margin you need to put down will depend on the broker you’re using and the asset you’re trading. It’s important to remember that the margin is not a fee charged by the broker – it’s simply the minimum amount of capital required to open the trade.
When you open a trade, your broker will set aside the required margin from your account balance. This money will cover any losses you make on the trade. If your trade is profitable, your profits will be credited to your account and can be used to cover any losses on other trades.
How can you use margin to your advantage?
Margin can be a valuable tool for traders, as it allows you to open more prominent positions than your account size would typically allow. You can potentially make more profits as your potential gains are magnified. However, it’s important to remember that margin also magnifies your potential losses. It’s therefore essential to use stop-loss orders and other risk management techniques to minimise the possibility of loss.