Trading on Margin: Education

It is critical to invest sufficient time and effort to fully understand what you are doing especially when this relates to CFDs, where the utilisation of margins to magnify up your gains can just as rapidly and mercilessly deliver massive losses.

Newcomers to the derivatives market often fail to realise that leverage is there as an option and that they are not obliged to use margin for their trading. Blinded by the vision of instant riches, many investors tend to leverage themselves to the with the inevitable consequence that should the market move rapidly against their position, they would end up with a potentially ruinous loss.

‘Contracts for Difference (CFDs) have really come to prominence over the last decade and private investors are beginning to take advantage of the
opportunities on offer.’

Investment Risk

When you buy a CFD over a stock, index or commodity (referred to as ‘going long’), you hope that the value of that underlying asset will rise, so you can sell the contract for difference for a gain. If you a sell a CFD over a share, index or commodity (referred to as ‘going short’), you hope that the value will fall. Remember however that if things go wrong, your losses could outweigh any gains you have made.

CFD providers typically ask for an initial margin of only 10 to 15% if you want to deal in UK blue chip stocks. A 15% deposit margin means that to have exposure to £10,000 worth of a particular share you only have to lodge £1,500 which equates to seven times leverage (10,000/1,500). This frees up £8,500 to invest, utilise or deposit elsewhere, but should your position move against you, you will be required to deposit more money (so called ‘variation margin’) to reflect or cover the loss that has been created by the adverse movement of the stock price.

Because contracts for differences are highly leveraged, even a small change in the underlying market can have a big impact on your trading returns. If a shares CFD is traded on 5% margin it allows the investor to take out a position in 20y times as many shares as they could were they to invest directly in the underlying. If changes in market value have a negative effect on your trade, the CFD broker may ask that you put additional funds in at short notice (called a ‘margin call’) to cover the adverse change and keep your position open. If you cannot meet this margin call, you may have to sell at a loss, or the CFD provider may close out your trades at a loss without consulting you.

‘CFDs are structured such that investors pay down a deposit or margin on their investment, but if the stock price falls, they have to pay further sums to maintain the margin at an agreed level.’