The online world is fascinating and diverse but may also be tricky. Today, trading platform users can operate tools that used to be available to professionals only in the past and for this reason they often forget about the risks to which they are exposed on the stock market.
With the Internet and all kinds of applications, anyone can trade securities these days if he or she is interested in them and has the guts to do so. You do not have to go to the bank, search for a bright banker or have the most powerful computer with multiple screens at home, which you must have seen in various Wall Street movies.
All you need is a smart phone
You do not need anything else but a simple smart phone to which you download the free Metatrader application and you can start trading anytime and anywhere. However, it is not always that easy and therefore, if you lack absolute confidence in your judgement you tend to follow the trading behaviour of a selected investor or a firm.
Contracts for differences
Contracts for differences started occurring in early 1990’s and initially, they were used by investment institutions as a security against price movements of stocks and other assets. With time, they have become products applied on the market by minor investors and traders.
A trader using CFD instruments does not become the owner of the physical stock and as such, he or she is not entitled to any profit share and possesses no decision-making powers.
CFDs, or financial derivatives, are used to speculate on price movements. They start with opening a position and end with its closing. You can speculate on price decline or growth and once the position is closed, your speculation is compared to the actual price movement. A profit is generated or a loss incurred, which is subsequently multiplied using financial leverage that can increase your capital with substantially higher volumes from external sources. Trading with the highest possible amount naturally results in increased gains but, unfortunately, also potential losses.
Below is a simplified example illustrating how financial leverage works within CFD:
We will use the movement of Amazon stocks between 8 July 2020 and 9 July 2020. Amazon stocks amounted to USD 3,011 (on 8 July 2020 at the start of the trading session). On the following day at the end of the trading hours, they amounted to USD 3,182, going up 5.68%. In the table showing examples of trades, leverage ranges from 1:1 to 1:5. We can see three different results depending on the leverage ratio. Profit or loss is generated or incurred depending on whether we speculate on decline or growth. We will provide examples under which a trader expected AMZN stocks to go up and speculated on growth.
*Fees: The table shows ‘spread’, a brokerage fee calculated from the trader’s profit as a difference between the buy and the sell price. For fees and details of the calculation, refer to the BCM documents.
Let us assume that on 8 July at the start of the trading session, a trader opened a position of USD 10,000 speculating on growth and closed it the following day in the evening. The market actually went up. Without using leverage, the trader generates a profit of USD 568. When using leverage of 1:5, the trader’s profit amounts to USD 2,840. The loss would have been the same had he speculated on price decline.
High gains thanks to leverage
The example clearly illustrates how financial leverage can help achieve high gains, however, it is also capable of causing high losses. It is thus important for investors to realise what their risk appetite is. If they are only willing to get exposed to low risks, stock trading using CFD will not be their cup of tea. Also beginners should avoid trading with leverage.
Risks of leverage trading
For those with a positive attitude to risk, trading with leverage may be a welcome part of new adrenalin opportunities that may satisfy their desire for profit. However, you should be aware that even experienced traders usually do not use a leverage ratio greater than 1:5. Nevertheless, if you follow reasonable risk management rules, a trading system with greater leverage may be established. Basic terms are explained, for example, at https://begincapitalmarkets.com/.Go back