CFDs: The Basics
30 October 2018 | Neville Lahner
 


Most people who are interested in trading markets will have come across the term "gearing", or "leverage", especially in reference to derivative trading. 

The most widely traded derivative instruments (especially in South Africa) are contracts for difference (CFDs). The explanation is in the name: you take out a contract with a broker for the difference in the price of the underlying asset (in this case equity). This sounds relatively complicated, but in practice it is actually quite simple.

I’ll start with the basics. Let’s say you ask your broker to buy 1000 Sasol shares at R500, and you expect the share price to move to R510.  If it does, and you then sell your shares at R510 each, you will make 1000 X R10 resulting in R10 000 profit before broker fees. The difference when comparing this trade on an equity vs. CFD basis, is as follows:

Equity:

Purchase 1000 shares X R500.00 = R500 000 (exposure)

+ Fees: R500 000 X 0.5% = R2 500

+ 0.25% (securities tax) = R1 250

Total cost of investment after fees = R 503 750

Then,

       Sell 1000 shares x R510.00 = R510 000

       less fees: R510 000 x 0.5% = R2 550

Total income after fees = R 507 450.

Profit: R 507 450 – R503 750 = R3 700

CFD:

Purchase 1000 shares X R500.00 = R500 000 (exposure)

+ fees: R500 000 X 0.3% = R1 500

+ No securities tax

Total cost of investment after fees = R 501 500

Then,

       Sell 1000 shares at R510.00 = R510 000

       less fees: R510 000 x R1 530

Total income after fees = R508 470

Profit: R 508 470 – R 501 500 = R 6 970

So the obvious difference is the reduced fees when trading the same-sized exposure, primarily due to not having to pay 0.25% securities tax on the purchase side.  However the primary reason traders often choose CFDs over equities for their short-term trading is the capital outlay between the two instruments. When you trade an equity, you need to put the entire exposure amount into the trade. When you take a CFD trade for the same exposure, you often only require 10%-30% of the exposure as upfront capital.  So for the example above, in order to take a R500 000 position in Sasol, you would only require R50 000 capital. This amount is referred to as margin, and can be considered a "deposit" for the position taken.

This outlay of R50 000 to get exposure of R 500 000 is what is known as gearing.  And this gearing is what needs to be managed in order to be a successful derivatives trader.

There is also one very important factor to remember when trading CFDs, and that is the interest charged on your exposure. With a margin of R50 000 you have been given access to exposure of R500 000. That means you have in fact taken a loan of R500 000, and that will incur interest charges. So, the longer you hold the position, the more your interest charges will be. For this reason CFDs are recommended for short-term trading rather than long term. 

The last advantage of CFD trading is that it will give you the ability to short the market. Shorting involves selling a share and then buying it back later. Using the above example of Sasol, let’s say you think the price of Sasol will fall from R500 to R490 per share. You sell it at R500 per share, and if the share price falls, you purchase the shares back at R490, making R10 profit per share. This selling of shares without actually having them is facilitated by your broker. You borrow the shares from the broker, sell them in the market and when you buy them back, the shares are returned to the broker. Being able to profit from a falling market gives one the opportunity to make money irrespective of how the market is behaving.

Your broker is there to assist you in understanding how to trade derivatives. Also, making use of a demo account can be useful in understanding how gearing works and how to short stocks. Getting comfortable with the principles of derivative trading is critical before committing real cash into the market. 

 

Neville

Neville Lahner
Portfolio Manager

Neville has been a full-time client portfolio manager since 2002.  He has completed a Unisa degree in Economics, The Registered Persons Exams (RPE’s), JSE Equity Traders Exam, RE5 (representative), RE1 (Key Individual) and RE3 (Hedge Funds).  He has traded in numerous dealing rooms across South Africa, and has 16 year’s experience, his primary focus is on short-term trading strategies using derivative instruments.


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