Contracts for difference (CFDs) allow traders to speculate on price movements without owning the underlying asset. A key feature that distinguishes CFDs from traditional investing is leverage, the ability to control a large position with a relatively small deposit. While leverage can magnify profits, it equally magnifies losses, and many retail traders lose money using it. According to the European Securities and Markets Authority (ESMA), 74-89% of retail CFD accounts lose money on average. Understanding how leverage works, and why it is risky, is essential before trading.
This article explains the mechanics of leverage in CFDs, the concept of margin, realistic examples with proper nouns and prices, and the specific risks that make leverage dangerous for inexperienced traders.
What Is Leverage in CFDs?
Leverage in CFDs means you can open a position worth many times your deposit. Your broker provides the remaining capital as a loan. The ratio between your deposit and the total position size is called the leverage ratio. For example, a leverage of 30:1 means you can control a position worth £30,000 with a deposit of £1,000.
Regulators in different jurisdictions cap leverage for retail clients. Under ESMA rules in the European Union and the United Kingdom, maximum leverage for major currency pairs is 30:1, for indices like the FTSE 100 it is 20:1, for gold it is 10:1, and for individual equities it is 5:1. In Australia, ASIC caps leverage at 30:1 for major forex pairs and 20:1 for indices. In offshore jurisdictions such as the British Virgin Islands or Seychelles, brokers may offer leverage as high as 500:1 or 1000:1.
Leverage is expressed as a multiple or as a percentage of margin. A 2% margin requirement is equivalent to 50:1 leverage. A 1% margin equals 100:1 leverage. The lower the margin requirement, the higher the leverage.
How Margin Works
Margin is the amount of money you must deposit to open and maintain a leveraged position. There are two types of margin: initial margin and maintenance margin.
Initial margin is the deposit required to open a trade. For a CFD on Apple Inc. (AAPL) with a 5:1 leverage, if the share price is $150, the notional value of one CFD is $150. The initial margin is 20% of that, or $30. For 100 CFDs, the total notional value is $15,000, and the initial margin is $3,000.
Maintenance margin is the minimum amount you must keep in your account to keep the trade open. If your account equity falls below the maintenance margin level, the broker issues a margin call. You must deposit additional funds or close part of the position. If you fail to do so, the broker will automatically close your trade, potentially at a loss.
Margin Call Example
Suppose you open a long CFD position on the FTSE 100 index with a broker offering 20:1 leverage. The index is at 7,500 points. One CFD is worth £10 per point, so the notional value is £75,000. Your initial margin is 5%, £3,750. The index falls 250 points to 7,250. Your loss is 250 × £10 = £2,500. Your account equity drops from £3,750 to £1,250. If the maintenance margin is 2.5% of the notional value (£1,875), your equity of £1,250 is below that level. The broker issues a margin call. You must deposit at least £625 to bring equity back to £1,875. If you do not, the broker may close the trade, locking in the loss.
Realistic Example: Leverage in Action
Consider a retail trader in the UK using a CFD broker regulated by the Financial Conduct Authority (FCA). The trader wants to buy CFDs on shares of Barclays PLC (LSE: BARC). The share price is 160 pence. The maximum leverage for individual equities under FCA rules is 5:1.
- Notional value of 1,000 CFDs: 1,000 × 160p = £1,600
- Initial margin (20%): £320
- If the price rises to 176p (+10%), the profit is 1,000 × 16p = £160. That is a 50% return on the initial margin of £320.
- If the price falls to 144p (-10%), the loss is also £160, a 50% loss of margin.
With a 10% adverse move, the trader loses half the deposit. Without leverage, a 10% move would result in a 10% loss. That is the double-edged nature of leverage.
Why Leverage Is Risky
The primary risk of leverage is that losses can exceed your initial deposit. In extreme cases, especially with high leverage and volatile assets, you can owe the broker money. This is known as negative balance. Many regulated brokers in the EU and UK offer negative balance protection for retail clients, meaning your loss cannot exceed your account balance. However, not all jurisdictions require this, and brokers in offshore zones may not offer it.
Other specific risks include:
- Margin calls and forced liquidation: A small adverse price move can trigger a margin call. If you cannot add funds, the broker closes your position, often at the worst possible time.
- Gapping: When markets open significantly higher or lower than the previous close, you can be stopped out at a price far worse than your stop-loss order. This happens frequently in earnings announcements or geopolitical events.
- Overnight financing costs: Leveraged positions held overnight incur swap fees or interest charges. For long positions, you pay the broker a rate based on the notional value. For short positions, you may receive interest, but often at an unfavourable rate.
- Psychological pressure: High leverage can lead to emotional decision-making, overtrading, and abandoning a trading plan.
Regulatory Caps on Leverage
Regulators have imposed leverage caps to protect retail traders. ESMA’s product intervention measures, effective since 2018, limit leverage for retail clients as follows:
- Major forex pairs: 30:1
- Non-major forex pairs: 20:1
- Major indices (e.g., FTSE 100, DAX 30): 20:1
- Gold: 10:1
- Commodities other than gold: 10:1
- Individual equities: 5:1
- Cryptocurrencies: 2:1
These caps reduce the risk of rapid account depletion but do not eliminate it. Even with 5:1 leverage, a 20% adverse move wipes out the entire margin.
Leverage vs. Buying the Underlying Asset
When you buy shares directly, you pay the full price. A £10,000 investment in Barclays shares requires £10,000 in cash. If the shares fall 20%, you lose £2,000 but still hold the shares. With a CFD using 5:1 leverage, you control £10,000 worth of Barclays shares with £2,000 margin. A 20% fall results in a £2,000 loss, your entire margin. You have no shares left, and the trade is closed.
This difference is crucial. Owning the asset allows you to wait for recovery. With CFDs, you can be forced out of the trade before recovery occurs. For a detailed comparison, see our article CFD vs. Owning the Underlying Asset.
Additionally, CFD traders can take both long and short positions. If you believe a stock will fall, you can sell CFDs and profit from the decline. Leverage works the same way on short positions, amplifying both gains and losses. Read more in Long vs. Short Positions in CFDs.
How to Manage Leverage Risk
Experienced traders use several techniques to control leverage risk:
- Use stop-loss orders: A stop-loss automatically closes a trade at a predetermined price. For a long CFD on Apple at $150, a stop-loss at $145 limits the loss to $5 per CFD. Without a stop-loss, a gap down to $130 would cause a $20 loss.
- Choose lower leverage: You do not have to use the maximum leverage offered. Using 2:1 instead of 5:1 reduces the risk of a margin call.
- Diversify: Trading multiple uncorrelated CFDs reduces the impact of a single adverse move.
- Monitor margin levels: Keep a close watch on your account equity and avoid adding to losing positions.
- Understand the product: Before trading, read What Is a CFD? and the Complete Guide to Contracts for Difference.
Conclusion
Leverage in CFDs is a powerful tool that allows traders to control large positions with small deposits. However, it carries significant risk, including the potential to lose more than your initial deposit. Regulatory caps in the EU, UK, and Australia limit maximum leverage for retail clients, but even modest leverage can lead to rapid losses if the market moves against you. Understanding margin, margin calls, and the specific risks of gapping and overnight costs is essential. Always use risk management tools like stop-loss orders, and never trade with money you cannot afford to lose.
For a broader overview of how CFDs work, including leverage, see the Complete Guide to Contracts for Difference.