On investment sites you will usually find a very complicated definition and explanation of what CFDs are and how they work. Below we try to simplify it, and show you how useful they can be.
What is a CFD?
A CFD (Contract For Difference) is an agreement between two parties (buyer and seller) to exchange the performance of an underlying instrument (listed shares, commodities or an index). Brokers normally act as the counterparty. The buyer will receive the difference in value if the price moves up (from the seller) and the seller will receive the difference if the price moves down (from the buyer).
The concept of gearing (also called leverage) is very important to CFDs. Gearing allows an investor to only deposit a small amount of the total value of the trade, yet his profit or loss is calculated on the total invested amount.
How does it work?
The CFD position is opened by making an opening trade (buy/sell) on a particular instrument. There is no expiry date. The CFD position is netted at the end of every day. This means that any profit or loss for that day is credited or debited to the client’s account, along with financing charges. This process is repeated for every day that the investor is in the position, until the position is closed.
In order to make it easy to understand how CFDs work, finance and brokerage charges are excluded from the example below.
You buy 1,000 MTN shares (MTN) @ R100 through Sharenet. The value of the transaction is R100,000, but the margin required is only R20,000 (20% of the value).
If the share price goes up to R105, you will make R5,000 profit. Since you only had to use R20,000 as margin, you made R5,000 on a R20,000 investment (25% profit).
The opposite is true if the share price goes down. If MTN’s price goes down to R95, you will lose R5,000 on a R20,000 investment (25% loss).
The above example shows the power of gearing and how useful it can be if used correctly.
CFDs have several other advantages – they are:
- Transparent pricing: All trades are executed in the underlying instrument in real-time, and the price you see is the live traded price.
- No expiration date: CFDs don’t have an expiry date, so you don’t need to roll them over and can hold them as long as you like.
- Dividends and interest: Clients receive dividends on their long positions and receive interest on their short positions.
- Low brokerage costs: Trading costs are very low compared to other instruments, making it easy to get in and out of positions.
- Trade short: Allows you to take positions in shares you have a negative outlook on, which is typically not possible with normal equities.
CFDs are a risky investment instrument that need constant attention and monitoring, but if managed properly they can be very effective in enhancing your returns.
Contact us to find out how we can help you incorporate CFDs as part of your overall investment portfolio.
Stephan is a portfolio manager and full-time trader. He developed his passion for the markets while working in the Stockbroking division of Standard Bank and is especially passionate about CFD trading. Stephan studied at the University of Stellenbosch and completed a BComm Honours (Business Management) with a focus in Portfolio Management and Bonds. He has also passed the JSE Equity Trader’s Exam, RE5 (Representative) and RE1 (Key individual) Exams as well as the Registered Persons Exams (RPEs) in order to give advice on equities.