Why you must respect the gearing aspect of CFDs
Contracts for difference (CFD) appeal to traders thanks to the money multiplying effect of gearing.
But this gearing also works against you. If you don't run tight stop losses, you're at risk of hefty losses.
Let's take a closer look at how you can rack up significant losses if a trade doesn't work out as you hoped…
The gearing aspect of CFDs comes from trading on margin
When you trade CFDs
, you trade on margin. By putting down a small deposit, you have exposure to a much larger value of shares. This is gearing at work
If a trade goes as you anticipate, you can make substantial profits, but gearing also works against you. If a trade doesn’t perform as you hope, you can make large losses.
Let’s see how this works with the help of an example…
You’ve been doing your analysis and believe Company ABC is undervalued and is going to rise in value. So you decide to buy 200 CFDs.
Company ABC is trading at R37.40. By buying 200 CFDs, your total exposure is R7,480 (200 x R37.40). If the margin requirement to open the trade is 10%, you need to put down R748 (10% x R7,480) to open the trade. And you pay R37.40 in brokerage.
You pay a R1.64 financing charge for holding the position overnight.
The impact of gearing on your losses when trading CFDs
The following day, the price of Company ABC takes a tumble to R35/R35.20, so you decide you’ve got it wrong and decide to exit your trade. You sell at R35.
Your broker also charges you R35 to close the position.
So how much have you lost on the trade?
To work this out, you need to do the following:
Work out the difference between the opening and closing value of the position:
Closing value of trade – opening value of trade = -R480 (R7,000 – R7,480).
Total brokerage paid to enter and exit the trade:
Total financing paid:
You total loss is R554.04 (-R480 – R72.40 – R1.64). That’s a 74% ((R554.04/R748) x 100) loss based on your initial margin.
This example illustrates why it’s vital to run tight stop losses as the losses can quickly mount up when a trade doesn’t go as planned.
So there you have it. Why you must respect the gearing aspect of CFDs.