Contracts for Difference (CFDs) are popular, especially in Europe, mainly due to leverage – the ability to deposit a small amount as collateral and borrow money from the broker in order to trade larger position sizes. Because some people think leverage is 100% and some generally exaggerate when using, we need to clarify a few things, so if you’re just getting started with CFD trading, you’ll know how to use it responsibly.
#1 Leverage in the context of risk management
“What is the most appropriate leverage level?” you may ask, thinking that there’s a certain threshold not to be exceeded. In reality, leverage on its own is irrelevant. You must think from a risk management point of view, meaning you must consider a few variables, not just the leverage. If you risk losing your entire account when the market moves in the opposite, then you clearly must take some actions.
You must adjust your position size and use risk diversification methods in order to not get wiped out by a single losing trade. Risk management is not just about leverage. It’s about position sizing, the risk per trade (how much in % terms you will lose if you’re wrong), your accuracy (meaning the percentage of winning trades), and last but not least, the risk/reward ratio. All these variables will help you calculate your risk of ruin or the probability of all your money.
#2 Reducing the leverage once your account grows
One of the common mistakes around retail traders is to increase their risk and exposure after a winning period. They get overconfident about their trading abilities and take higher risks, only to end will less money than they originally had. Trading is like a marathon and there’s no easy way out of it. Reducing the leverage as your account grows will show that you’re not only treating trading responsibly but will also show great emotional control.
We can’t suggest any particular level for the leverage. Some experts say that leverage higher than 1:10 means you’re gambling, and some consider 1:100 as the maximum level. As we’ve seen previously, you should put leverage into a greater context, not isolate it aside from other important risk parameters.
The bottom line is that risk management is a trading skill and leverage is one of the key components of it. If you can’t afford to invest a lot of money, then obviously you’ll have to use higher leverage at the beginning. Make sure, however, to stick to strict rules of risk management, so the risk won’t get out of control.