Beware very low CFD Margins

Q:Why shouldn’t you regard ‘low margin requirements’ being flaunted as a selling point by some providers?

A: A characteristic of CFDs is that they have lower margin requirements than other types of leveraged vehicles. Gearing (leverage) is the degree to which an investor is able to make use of borrowed money.

Just keep this in mind: The lender (contracts for difference provider) is focused on maximums whereas the borrower (you!) should be concerned with minimums – borrowing as little as you can but still getting bang for your buck.

Now to turn to your CFD trading account: you want to increase your speculative capacity by leveraging your capital, thereby you borrow money to trade with from your broker.

Before your CFD broker will lend you money you have to put down an initial margin amount, that will be used to lever with. Your CFD provider, being a prudent businessman has calculated his risk beforehand and is quick to tell you about the maximum amount he is willing to permit you to borrow from him. In contracts for difference this can range from anything between 5% and 90% depending on the volatility and liquidity of the underlying market.

Margin is usually expressed as a percentage, while leverage is expressed as a ratio.

This doesn’t mean that you should utilize all your borrowing power with your CFD broker – in fact it would be highly imprudent for you to do so!

Suppose there is £5,000 in your CFD trading account and you entered a long position on £50,000 Virgin stock using CFDs. The market closes and Virgin announces that it has realized losses for the previous quarter of over £10 million due to various factors. When trading continues the next trading day, the stock for Virgin has fallen 30%, which means that you are £15,000 down. If there is only £5,000 in your trading account, the CFD broker will inform you that you need to deposit a further £10,000 or the trade will be closed. This is known as a margin call. The stop out level varies between providers, which is the level at which open CFD positions may be closed, but it is generally when you have less than 40% of your required initial margin, i.e. 40% of your position size.

Picking a broker with the lowest margin is not always the best choice and may be dangerous. Why? The marketing wizards at CFD broker houses have realised that the fact that they can offer clients very high gearing ratios will work to their advantage in their quest of attracting more online investors from the traditional markets. Furthermore, many online investors portfolios were devastated by the 2008 crash and losses of more than 50% of formerly lucrative stock portfolios became commonplace and as a result today we have some providers touting from the rooftops that they only require 3% margin upfront. In reality the CFD broker is simply stating that they will allow you to gear at the absolute maximum if you utilised all the borrowing power from your broker.

But you must remember that gearing is a double-edged sword. It can work for you and against you. And so a race started amongst the CFD losers out there: where were the highest leverage , lowest margin and narrowest spreads being offered? As if this lethal combination would contribute to success…

Leverage IS NOT what your CFD provider will allow you to use, it is what you decide to use. The prudent application of leverage cannot be stressed far enough. Most CFD brokers will tell you how much they will allow you in terms of gearing, should you want to but not how much you should leverage.

Even if you were to find out a provider with the lowest margins, just keep in mind that regardless of how little initial margin you pay upfront, you are always responsible for the full market value of the trades you execute. Paying less deposit margin upfront simply means that smaller price fluctuations can have a bigger impact on your trades. For instance, let’s assume you have an open trade and the market moves against your position, the CFD broker may ask you to put in additional funds to keep the trade open. If you have excess cash in your trading account, this additional margin will be automatically deducted. In cases where you don’t have sufficient monies in your CFD trading account, the CFD broker may make a margin call demanding additional funds!

Statistically speaking over-gearing yourself is statistically the main culprit for blowing out accounts along with scaling into trades and averaging down. I think it is also very important to keep your share sizes consistent in all CFD trades and not think that one trade looks ‘like a perfect setup’ and to then over leverage yourself on that trade. Keep in mind even the most perfect looking trade can go wrong on you in a split second.

Q:Is it possible to trade without gearing?

A: I only know one provider where you can trade without utilising leverage and the provider is Ayondo. Normally, with the other providers there is no way to trade without leverage on CFDs. So you can’t really do 100% margin, but if you are disciplined enough, you can keep yourself honest (maybe with a spreadsheet or something). You can also buy the amount of shares that would equal what you want to invest in a normal account, and leave the rest as surplus.

Q:What is a margin call?

A: A margin call happens when you have insufficient funds in your account to cover your margin requirements and running losses. When this occurs your account comes into margin call and you are at risk to have your position closed out at any time.

Example: If you have bought £10,000 worth of an instrument, which requires a 10% margin (ie. £1,000), then as soon as the total equity on your account falls to £1,000 or below, then you will have insufficient funds to cover your margin requirements, so your broker will send you a margin call email. This will inform you of the situation and it will request you to either deposit more funds to your account, or reduce the position size (thus reducing the margin requirements), if you wish to keep the position open. In practice you can also close one or more of your open position(s) to reduce your initial margin to the required level.

Margin Call Example

Suppose you were trading with a provider that had the lowest margins. If you enter a long position and the market makes an unexpected downward move, the CFD broker will ask you to add additional funds to keep the position open. Additional margin is automatically deducted if there is any excess funds in the trading account. However, if there are insufficient funds, a margin call is made by the CFD broker, requesting additional funds. The following example illustrates how margin calls work.

Let’s say you have £1,000 in your CFD trading account and went long for £10,000 in Apple stock. The market closes and Apple announces that it is withdrawing its iPhones from the market due to an industrial defect in the manufacturing process. When trading resumes the next trading day, let’s suppose Apple stock has fallen 20 per cent on the open, which means you are $2000 down.

If you only had $1000 in your CFD trading account, your CFD broker will inform you that you need to deposit a further $1000 or the trade will be closed. And even then, you would still owe $1000.

Stop Out Level

You will be in danger that your open CFD positions may be closed whenever you have less than 40% of your required initial margin (i.e. 40% of your position size), although this may vary between CFD providers.