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The basics of CFDs: Getting to grips with gearing and the margin

by , 18 June 2015

One of the reasons that traders choose contracts for difference (CFDs) is the gearing aspect they offer.

Gearing amplifies the movement of the underlying share price. This can work for you by multiplying your potential profits, but against you too as it also multiplies your losses.

Gearing comes from trading on margin.

Read on to find out how this work…

The impact of trading CFDs on margin

Let’s look at what difference it makes to a trade when you trade on margin…

Say Company ABC is trading at 100c a share.

Jack decide to buy 1,000 shares. This costs him R1,000.

Two months later, the share price has risen to 150c, so he decides to sell. He receives R1,500 (1,000 x 150c). That’s a R500 profit (R1,500 – R1,000).

By not trading on margin, Jack makes a 50% profit from a 50% share price rise.

Sally decides to do the same trade, but she buys CFDs, which trade on margin. By trading on margin, she gears up the money she has to trade with.

So Sally buys 1,000 Company ABC CFDs trading at 100c each. Her total exposure is still R1,000, but the margin requirement is only 10%. This means she only has to deposit R100 to open the trade.

Two months later, when the share price hits 150c, she sells. But as she’s trading on margin, Sally also makes a profit of R500, but this is a 500% profit on her initial margin, much more than Jack’s 50% gain.

(For simplicity, these examples exclude trading costs.)

You may already have bought on margin

But buying on margin isn’t just for trading shares. You may already have put the principle to work when buying a house.

Say you buy a house at R1 million. Chances are you’ll go to the bank for a loan to cover the bulk of the cost.

If you put down 10% of your property’s value, you take possession of your house and move in, but you only paid for a fraction of it. This is exactly the idea with trading on margin.

If you’re house rises in value and you sell, you get to keep the profit too.

So there you have it. Getting to grips with gearing and margin.

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The basics of CFDs: Getting to grips with gearing and the margin
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