Gearing, Margin and Leverage

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Gearing, Margin and Leverage

Q.: What is Margin?

A: CFD trades are margin-based transactions. Margin refers to the deposit the stock market trader must provide in order to open a position. For instance, if Barclays has a margin of 10%, the client can pay 10% of the total market position value while borrowing the remaining 90% from the CFD provider. In other words, the trader entering a contracts for difference trade is only required to put up a fraction of the total value of the specified contract traded. Margin money is essentially a guarantee that the person (trader) will honor the contract entered into with the broker. Margin is set based on risk and on what it would cost to buy the investment for its full price. By trading on margin, the trader can acquire a larger exposure to a particular stock for a reduced amount of money.

Margin is thus the minimum deposit you are required to make by your CFD provider so you can open your CFD trade. Your risk level will depend upon your margin covering your margin trade. The amount required to initiate a new position (i.e. enter a trade) is referred to as 'Initial Margin'. Initial margin is usually set at a percentage of the value of the contract being traded. The Margin is set by the CFD provider.

Q.: What is Maintenance Margin?

A: It is important to note that the value of all contracts for difference positions is constantly being monitored and re-assessed by brokers. As a trader an important part of the contract is that you must agree to maintain the positions at the required deposit value on an ongoing basis.

Maintenance margin also sometimes referred to as variation margin is the amount of margin that is needed to maintain a position (remain invested in a trade). Initial margin is always higher than maintenance margin, so for as long as the initial margin is covered you do not have to worry about the maintenance margin. Usually, maintenance margin is about 75% of initial margin. When the available monies in your margin account are reduced by losses to below a certain level, known as the maintenance margin requirement, you will be required to deposit additional funds to bring the account back to the level of the initial margin. Or, you may also be asked for additional margin if the exchange raises its margin requirements.

For instance, if the initial margin for gold is $2,000 and the maintenance margin is $1,500, you would need to have $2,000 allocated from your account as initial margin to trade the gold contract. Positions are marked-to-market every day meaning that every position is valued at the close of each business day with any profits credited to your trading account and losses deducted. This means that the current price is compared to the previous day's price and should losses on the position amount to, say, $600, the value of your initial margin would be reduced to $1,400, which is below the $1,500 maintenance margin requirement. Therefore, extra funds in the amount of $600 from your account would be automatically allocated towards bringing the initial margin figure back to $2,000. If there were not excess funds in the account to bring the initial amount back up to $2,000, the trader would have to meet the margin call promptly as otherwise the position would be liquidated by the broker which means having your investments sold by the provider because you can't meet the margin top up requirements.

Q.: What is a Contingent Liability Transaction?

A: Contingent liability investment transactions are margined transactions like contracts for difference which require you to make a series of payments against the purchase price, as opposed of paying the full value of the contract immediately. If you trade in futures, contracts for difference or sell options you may sustain a total loss of margin you deposit with your broker to establish or maintain a position. Should the market move against you, you may be called upon to pay the additional margin at short notice to maintain the position (commonly known as a margin call). If you fail to do so within the time required, your position may be liquidated at a loss and you will be responsible for the resulting deficit.

Q.: What is gearing (or leverage)?

A: Hedge funds use it, so do a number of exchange-traded and investment funds. Daytraders too. Leverage (or gearing as it is sometimes referred to) is much like borrowing: it allows you to increase your potential return on a trade as you increase your exposure to the market.

Gearing, as in the mechanical sense, is the process of turning a small effort into a large output (examples: in a lever or in a bicycle's gears. In financial terms gearing has the same effect: it enables a customer to trade a position in much larger size than the margin that is deposited with the CFD broker, e.g. For an initial deposit of £1,000, a customer can buy or sell £10,000 of a FTSE 100 share (This is 'gearing' or leverage of 10:1). Gearing when used this way is also sometimes referred to as investment gearing.

Gearing in CFDs enables traders with a small float to make good profits from trading the stock market. In other words, gearing or leverage magnifies investment returns and can even help you diversify a trading portfolio as it frees up capital which can then be deployed in other investments. For instance your trading system might be designed to make a 25% return per annum. With a $5000 float, this would produce $1500 in profit in one year. However with CFDs because of the gearing the same system could potentially make a 300% return, which would be $15 000 profit in one year. But it is important to understand that gearing (leverage) is a double-edged sword and an asset can fall as well as rise thereby potentially magnifying your losses.

Q.: Do all CFDs have the same level of leverage, what is the leverage?

A: No, it varies widely from as low as 1% to as high as 75% depending on the specific instrument. Most share CFDs in the ASX 300 and FTSE 100 are around the 10% mark. If you are looking at foreign exchange then you can get much higher levels of gearing simply because stocks are much more volatile whereas a currency moving high in value in a short-time period is relatively unlikely although it has happened recently with a number of currency pairs so it very much depends on the product that you are trading.

Q.: What is NTR?

A: NTR stands for Notional Trading Requirement and refers to the amount of deposit to support an open position in addition to any losses.

Q.: What margin is required for a CFD?

A: The standard margin is 10 per cent of the contract value. A contract for difference with a contract value of $10,000 will require a margin/deposit of $1000 (check with your CFD broker for other margins).

Q.: Why do margins vary?

A: Liquidity and volatility of the underlying security dictate margin.

Q.: Just wondering what the effect is in comparison to small leverage say 3/1 and then more 5/1 10/1 and more.

A: In forex, if you are using 1:1 leverage , and your trade moves 3%, your account will go up or down 3%. With 5:1 leverage , when your trade moves 3%, your account will change 15%. With 10:1 leverage, your account will change 30%.

If you do not want to use leverage and only want to use 1:1 then your position size should not exceed than what the balance of your account is. For instance if you have an account balance of $10,000 and you make a trade for $10,000 then you are not leveraged.

The way high gearing effects traders is the emotional reaction a trader has because such a large percentage of their account is on the line. Greed and fear are the usual reactions.

How this applies to the technical aspect of the trade is that to follow proper money management , you will be forced to really tighten your stops. Higher gearing (i.e. leverage) means a bigger position size. Which follows that to keep your maximum loss of say 2% per trade, you would need to place a really tight stop. But it is important that you do not place a stop loss just because that point is where you are not prepared to risk more money. You first need to make sure you are looking for a support level and then decide on the amount of money you are willing to risk or lose if you make it to that level and lastly set your share size accordingly. Make sure you don't just pick a spot and say 'well here I will be losing $500 so I need to make that my stop loss '.

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 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 what the maximum is he will allow 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!

The marketing wizards of CFDs have realised that the fact that they can offer very high gearing will be to their advantage to attract 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 as 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.

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: 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.

 ...Continues here - Risk per Trade and Position Sizing