Online trading platform users now have the professional stock traders’ tools at the hand’s reach, but often underestimate risks.
The online world enabled access of stock trading to broad public and it is no longer a privilege of selected groups of people. Nowadays we don’t have to go to a bank or search for a broker, in theory we don’t even have to consult what and how to trade and invest into. We don’t even have to own a powerful computer with lots of screens as we see in movies related to Wall Street investment bankers. We could get similar profits with a simple smartphone where we download trading application for free, for example Metatrader. We can be trading literally anywhere and anytime. And if we don’t trust our judgment, we may use so-called “social trading” which means setting our trading rules in a way that copies investments by a selected investor or a company.
We now show you leverage trading on an investment instrument called “contract for difference”, also known as CFD.
Leverage trading: high profits and high losses
As opposed to stocks or currencies, contracts for difference have been used in trading and investing only recently – since 1990s. At the beginning they served financial institutions to hedge against exchange rate movements of stocks and other assets. It was only later when they became a product traded by smaller investors and traders.
When using CFD instruments, the trader does not become an owner of a physical stock, which means he also does not have any rights to profit or voting rights. On the other hand, the trader does not have to pay any stock charges and CFD trading is faster and easier in comparison to traditional assets.
CFD are financial derivatives that are used for price movement speculations. In simple words, CFD is created by opening a position and is finished by closing a position. Traders may speculate on price decrease or growth. When closing a position, trader’s speculation is compared to the real price movement, which means a calculation of a profit or loss. This is then multiplied by financial leverage usage, that enables traders to add usually significantly higher amount of foreign capital to their own capital.
Trading with higher “amount” then leads to profit increase, but also to higher potential losses.
For a better understanding of how financial leverage in CFD trading works, we present you a simplified case. We will use Facebook stocks movements between 17 and 18 June 2019. Facebook stocks were valued at 185 USD (on 17 June, at the beginning of trading session). On the following day, the stocks were valued at 185.5 USD, which meant an increase by 1.89 %. In the table you can see examples of trades where leverage is used, from 1:1 ratio to 1:5 ratio. There are three different results according to the leverage level. A profit or loss is created based on the decision to speculate on growth or decrease.
We now present you a case where the trader expected Facebook stocks growth and speculated on it.
*Charges: the table shows so-called spread, that is a charge of the broker which is calculated from trader’s profit from the difference between buying and selling price. More information about charges and detailed calculations are available in https://alpho.com/.
Let’s assume that the trader opened a position on 17 June at the beginning of a session with the volume of 10,000 USD, speculated on growth and then closed it on the following day in the evening. The market really went up. Without using leverage, the trader would earn a profit of 189 USD. If he used a leverage of 1:5, his profit would be 946 USD. On the other hand, he would have same amount of loss, if he had speculated on price decrease.
As you can see in the example, the leverage may help to higher profits, but it may also cause losses of the same height. That’s why it is necessary for the trader to realize, how high his risk affinity is. If the investor requires a low level of risk, stocks trading using CFD would not be his cup of tea. Market beginners are also not encouraged to use leverages. For investors with a positive attitude towards risk, this type of trading may be a welcomed member of the portfolio, although even experienced traders usually do not use higher leverage than 1:5. If the trader incorporates reasonable rules for risk management, a trading system with higher leverage may be created. More information and basic glossary may be found in Alpho website here.