Risk & leverage

Leverage

Unlike most traditional financial dealing services, a CFD is a leveraged product. This means that your initial deposit payment gives you exposure to a comparatively larger portion of an underlying market than if you bought the instrument directly (via a stockbroker for example). Leverage is one of the key advantages of CFD trading, as it allows you to profit from a market without having to put up the full value of the position.

However, this magnified exposure also means that CFDs can result in losses that exceed your initial deposit. And without good risk management, it becomes possible to make significant losses over a short period of time.

One way to understand leverage is to compare it to buying a house. Imagine two investors buy identical houses for £500,000 each. Investor A pays 100% cash and Investor B pays just 10% and borrows the rest. For the sake of simplicity we will assume the loan is interest-free.

After a few years the value of the houses rise to £750,000 and both investors decide to sell. Investor A is very happy, his £500,000 is now worth £750,000 and he has made a 50% profit on his original investment. However, Investor B is even happier. He paid £50,000, and borrowed £450,000; after paying off the £450,000 loan, he is left with £300,000 in cash. He therefore has a £250,000 profit on his original £50,000 investment, or a profit of 500%.

Had the price of the property fallen to £250,000, both investors would be looking at a loss. If they sold their properties, Investor A would make a loss of £250,000 (50%), and Investor B would lose his £50,000 deposit and need to pay a further £200,000 - a total loss of £250,000 (500%) - negative equity. This clearly demonstrates the high-risk nature of leveraged dealing.

For example

If you bought £10,000 worth of ordinary shares, you would be expected to pay the full £10,000. However, if you opened a £10,000 CFD position in an equity with a required margin of 10%, you would initially only need to pay £1,000 (10% of the value). This means that you control the same size asset with a much smaller amount of money - in this case £10,000 for just £1,000. This 10:1 ratio means you have an investment with 10 times leverage. Therefore, assuming there was no spread, if the underlying share price went up by just 5%, you would make a profit of 50% - although if it went down by 5% you would also make a loss of 50%.

Superior Risk Management

You will have access to risk management tools which offer a range of possible protection methods against an adverse market move, letting you trade CFDs without assuming a potentially open-ended liability.

Guaranteed Stops

Guaranteed Stops offer the best possible protection, should the market move sharply against you. Guaranteed Stops put an absolute limit on your liability in the event of a violent market movement, without restricting your profit potential. When you place a Guaranteed Stop you set a maximum/minimum exit price for your trade. Your position will be closed at exactly your selected level should the market move against you, even if there is a very sharp overnight move.

There is a one-off extra charge, in effect an insurance premium, for this Limited Risk protection. In most cases this is just 0.3% of the underlying transaction value. Limited Risk protection is not available on all shares and the size of the position on which we may be able to offer this facility may be limited. IG Markets will be happy to advise you of the facilities available for any particular share.

The margin requirement for a Limited Risk trade is equal to the amount which would be lost if your Guaranteed Stop were triggered, plus 10% to cover any interest or dividend adjustments.

You can also access a full range of non-guaranteed orders to open and close CFD positions. These are available free of charge on most transactions.

Trailing Stops

Trailing Stops are part of the range of non-guaranteed orders, and allow you to track profitable positions automatically.

This new type of Stop order means you do not have to manually monitor your stops and move them constantly. Instead, the Stop automatically trails the underlying market, should it move in your favour.

You set the conditions for the Stop to move, including the distance from your opening level, and the 'Step' size - the size of the increments by which the Stop can move. Trailing Stops can be used on long or short trades, helping you to secure you gains as the market moves.

Setting up a Trailing Stop

There is no charge to use a Trailing Stop. However, you must first activate Trailing Stops for your account on PureDeal. To do this, simply:

• Go to Preferences (in My Account)
• Select 'Allow Trailing Stops'
• Accept the special terms and conditions
• Click 'Set Preferences'

You will now find a Trailing Stop check-box on your Deal Ticket for currency trades, plus selected indices and commodities.

Remember that even with Limited Risk protection, trading CFDs carries a high level of risk to your capital, which may not be suitable for everyone. Please ensure you fully understand the risks involved.