The difference between “investing” 2% and risking 2% of your portfolio - explained
New traders think that when I talk about risking risk 2% of their portfolio, it means investing 2% of what their portfolio is worth.
But that's not what I mean.
Let's say you have R10,000, and you only want to risk 2% or R200 of that amount to trade CFDs.
Here's how much you'll need to invest in your CFD trade…
First some investing/trading 101 basics
With shares, if you want to risk 2% of your portfolio, you’ll invest the full R200.
And if the share goes to zero, the maximum you can lose is R200.
But with CFDs it’s different.
When you invest 2% of your portfolio or R200, you can lose more than what you put in.
Well, you have to understand the concept of gearing.
Gearing is where you put in a small amount of money into your CFD investment, and you’ll be exposed to a much bigger sum. The amount you’re exposed to, is the amount of money you can potentially lose, if the share price drops all the way to zero.
Let me explain this with an example.
Let’s say Sasol’s share price is trading at R450. And you decide to buy one Sasol CFD.
If Sasol’s CFD has a gearing of 10 times, this means you’ll pay 1/10th of Sasol’s R450 price and still be exposed to the full R450 worth of Sasol.
Because Sasol’s gearing is 10 times, this means you’ll only pay R45 (0.10 X R450 per share) per CFD.
If Sasol’s share price crashed to zero, you can lose the full R450, even though you only invested R45 for the CFD.
But now I’m going to show you how you can invest a small amount of money and only risk 2% of your portfolio.
Let’s extend this example with the specifics in your investment with CFDs.
Step #1: Know how much you want to trade in your portfolio.
Step #1: Calculate how much you’re willing to risk in your portfolio
You know that you only want to risk 2% of your portfolio.
So step one is simply calculating what 2% of your portfolio value is.
Here’s the calculation.
(Portfolio value X 2%)
=R10,000 X 2%
Step #2: Calculate the rands risked in your CFD trade
Here are the specifics for your CFD trade
Stop loss: R430
Take profit: R490
Margin per CFD: 10% or R45.00
With this investment, you’re going to buy a number of CFDs at the entry price of R450 per Sasol share.
And you’ll place your stop loss (risk level) at R430.
This means, that you’ll allow the Sasol share price to go against you R20.
To calculate the rands risked in your CFD trade, you’ll subtract your entry price from the stop loss level.
Rands risked per CFD =Entry – stop loss
= R450 – R430
We also know that you have a R10,000 portfolio in your account to invest CFDs. Of that amount you’re only going to risk R200 or 2%.
So we’ll need to now calculate how many CFD contracts you’ll need to buy.
With your CFD example, you know that the margin per CFD is 10%.
And as I explained above this means you’ll pay 1/10th of Sasol’s share price.
So instead of paying R450, you’ll only pay R45 per CFD (10% X R450 per share).
Now that you know how much each CFD costs, you need to calculate how many CFDs you’ll buy (invest), to only risk R200 or 2% of your R10,000 portfolio.
Step #3: The number of CFD contracts you’ll buy
Before you get a little confused let’s sum up what we’ve done so far.
Step #1: Calculate 2% our R10,000 portfolio which we’re willing to risk=R200
Step #2: Calculate the rands risked in the trade between the entry and stop loss=R20
Now we can move on…
To calculate how many CFDs you can buy to only risk R200 (2%), you’ll simply divide what you’re willing to risk (R200) by the rands risked per CFD trade (R20).
No. of CFD contracts=(Max risk ÷ Rands risked per investment)
=R200 ÷ R20
So, with the above calculation, to only risk 2% you’ll buy 10 CFDs in this CFD investment.
And we know that each CFD contract costs R45 per CFD (Take a look at the specifics for the investment again).
So you’ll simply multiply the number of CFDs you’ll buy, which we’ve just calculated, to the amount of money you’ll pay for each CFD.
Initial margin in rands=(Margin per contract X No. of CFDs)
=(R45 X 10 CFDs)
The good news is, you won’t have to worry about risking the full R450 when you put it into your CFD trade, because you’ve placed your stop loss at R430.
So should the investment go against you and hits your stop loss, you’ll lose R200 of the R450 you deposit into your CFD investment.
If this seems like too much maths for you, I suggest you read through this section again.
Switch off the music, go into a quiet room and write down the calculations I’ve given you. And you’ll see that it will make 100% sense the second time you go through it.
To conclude everything.
You’ll simply deposit R450 to buy 10 Sasol CFDS. And because you place your stop loss at R430, you’ll only risk R200 or 2% of your starting portfolio (R10,000) in your CFD investment.
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“Wisdom Yields Wealth”
Head of Trading, FSPInvest.co.za