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Lessons learnt from a man who lost R1 million from a single mistake

by , 03 May 2013

A couple of weeks ago I was speaking to some brokerage buddies of mine. And one broker told me a morbid story. You see, one of his clients had a non-discretionary account. This basically means that it's totally up to the client to decide where to put his own money… And this particular client was absolutely convinced this one share in particular would skyrocket. Disregarding the broker's advice, this guy shovelled all his money into this one trade. Two days later the broker had to call this man with painful news…

Not only had he lost all the money he put into the trade (which amounted to R1 million), but the broker had to ask the man for even more money to cover what he now owed!
 
So how did this happen?
 
Let me explain…
 
Never invest in things you don’t understand
 
You see, the client didn’t just invest a whole heap of cash into a dodgy share – he invested in the share using a risky investment instrument called a CFD (Contract For Difference).
 
Now don’t get me wrong, this instrument can make you a LOT of money… But only if you know what you’re doing!
 
Investing in things without fully understanding the instrument can be a risky business, and detrimental to your financial well-being.
 
And for this reason I think it should carry a health warning.
 
Trading CFDs is similar to trading shares, except you only have to put a small deposit down to control the whole position.
 
This is all thanks to something called “margin.”
 
To help me explain what happened to this man, I’ll give you a small example.
 
Let’s say you have two investors named Jerry and Richard who have R20,000 each that they want to invest. They’ve both heard great things about ABSA and decide to put the full R20,000 in the company.
 
Let’s say ABSA, in this example, is trading at R200 per share.
 
Jerry decides to buy the actual share, therefore he pays R20,000 and receives 100 shares worth R200 each.
 
But Richard is a risky kind of guy and decides to use CFDs. The initial margin (amount required to place a trade) in this case is 10%...What this pretty much means is that he pays R20 for a single share instead of R200.
 
Sounds great right? But wait until you see what happens next...

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Since he has R20,000 to play with, he is essentially able to buy R200,000 worth of shares using only R20,000 and CFDs.
 
A few months later the share price drops from R200 and hits the R180 mark. Both of them decide they want to cut their losses and head for the hills before it drops even more.
 
What happens to Jerry is that he makes a loss of R2,000 calculated as [(R180-R200) x 100]. A ten percent knock on his investment seems bad, but it’s NOTHING compared to what happened to Richard.
 
You see, Richard put the same amount down as Jerry and even invested in the same share… But where Jerry lost R2,000, Richard managed to lose his entire investment of R20,000!
 
Since Richard used the margin and was exposed to 1000 ABSA shares, his losses came to R20,000, calculated as [(R180-R200) x 1000].
 
But the real problem here is that Richard didn’t fully understand the risks of CFDs and he exposed himself to too much risk.
 
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Investing on margin is a dangerous game – be careful
 
The thing is, CFDs amplify your winnings and your losses. So although it can be useful for maximising gains, you must remember...
 
Don’t invest in things you don’t fully understand!
Tags: cfd, trading, trade


Lessons learnt from a man who lost R1 million from a single mistake
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