Underlying asset prices may not move drastically most of the time. Hence, brokers will offer trading on margin for CFDs. This means that you’ll be borrowing money from the broker to increase the size of your initial investment. If the leverage is 20:1 (may also be stated as a margin requirement of 5%), this means that for every $1 you put in, you’re borrowing $19 to buy $20 worth of CFDs. This is a way of maximising returns, but also losses, in your investment!
Let’s say the current CapitaLand Limited share price is $4, and Jack plans to buy a CFD for 100 shares. The CFD value will be $400, but with leverage of 10:1 (or margin requirement of 10%), Jack will only need to fork out an initial investment of $40 (assuming no other fees charged; more on this later!). As such, his gains or losses will be measured against this $40.
If the share price rose to $5, Jack will have earned $100 from the CFD. This is a 250% gain on his $40. If the share price fell to $2.50, then Jack will have lost $150, theoretically. This is 375% of his initial investment.
However, you usually won’t lose more than your initial investment because your broker will typically ensure that you do not owe them any money. They do this by forcibly closing your position to immediately realise your losses or asking you to top up more money instead. All of this is facilitated through a margin account.
Note that $40 here is just an example of a small-picture scenario - it also does not account for any additional trading fees your brokerage will apply. CFDs are typically traded in the thousands and are hence very risky. Imagine losing thousands of dollars just because your underlying asset’s price fell by 5%*! Not sure if you’re ready for it? Seek out some professional advice!
*Depends on the leverage ratio.
The margin account is where your initial investment goes. It acts as collateral for your open position and ensures that you never owe any money to the broker, so both you and the broker can rest easy. If your CFD position makes a loss, your losses will be taken out of this margin account immediately.
When your margin account hits a minimum threshold, referred to as the Maintenance Margin Requirement (MMR), a margin call will take place to request that you top up your margin account. If you do not top it up, you will have your position forcibly closed by the broker (to prevent further losses and hence an owing of money).
Some brokers do not perform Margin Calls and will instead close your account immediately once the Maintenance Margin Requirement is hit. In this case, the requirement level may be called the Margin Closeout instead.
Let’s say that the MMR for the above example was set at 2.5%. Once the price of CapitaLand Limited Shares drops to $3.89, your margin account will bear all the losses and have $4,500, while your position will be $194,500, falling from $200,000. Your margin percentage is now 2.31% (= 4,500 / 194,500), below the MMR.
You will get a margin call to top up your margin account back to 5% (to maintain a leverage ratio of 20:1) of your current holdings. This means that you will have to top it back up to $9,725 (not $10,000) since the overall position of the current holdings is now $194,500 (not $200,000 anymore).
If you do not do so, then your position will be closed, and you will have lost the chance to recoup your losses if CapitaLand Limited share price subsequently rises. You will also have lost your entire initial investment.
If you top up your margin account, you will allow yourself to recoup the losses because the position is still open. However, your losses may now exceed your initial investment of $40 since you have put in more money.
As such, you can now see why trading CFDs are extremely risky!
CFDs: TRADING ON MARGIN/USING LEVERAGE. COMPLETED. ✅
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