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“So if this trade went sour would I lose the R4,500 or would I now owe R45,000”
This is a great question. And to make this simple as I can, the answer is both.
I’m going to explain how you can lose your R4,500 and how you can lose R45,000 when you trade CFDS. But there are ways to prevent this from happening.
Let’s break these two ways of losing money into the worst and best case scenario.
The worst case scenario where Tony can lose the full R45,000
Let’s say Tony deposits R4,500 to get into his CFD trade.
And Tony forgets to put in a stop loss.
This means, that the share price of the CFD can drop all the way to zero where Tony can lose more than his R4,500 initial deposit.
But before you start scratching your head. Let me explain this easily with the concept of “gearing”...
Gearing is where you deposit a small amount of money and be exposed to a MUCH larger sum.
Take a house for example. Let’s say you want to buy a house for R1 million. Do you pay the full million rand to own your house? NO.
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You’ll pay an instalment of around R10,000 a month to be exposed to your R1 million house.
With trading CFDs it’s very similar.
If you want to buy a Sasol CFD, you won’t have to worry about paying R450 for one CFD.
If Sasol’s gearing is around 10 times, this means you’ll pay a 1/10th of the Sasol share price.
So every 1 Sasol CFD you buy, you’ll pay R45.00 (10% X R450).
But when you buy 1 Sasol CFD, you’ll be exposed to the full price of Sasol’s share price.
And if you deposited R4,500, this means you’ll buy 100 Sasol CFDs (R4,500 ÷ R45.00 per CFD).
And because the gearing stays at 10 times, this means you’ll be exposed to the full R45,000 (R450 a share X 100 shares).
So let’s go back to Tony and how he can lose the full R45,000.
If Tony buys 100 Sasol CFDs at R45.00 per CFD, he’ll be exposed to R45,000 worth of Sasol shares (100 Sasol shares X R450 share price).
And if Tony didn’t put in a stop loss, and Sasol’s share price drops dramatically down to zero, Tony will be liable for the full exposure of R45,000.
So even though Tony deposited R4,500 into the CFD investment, he would now owe the bank R45,000…
But this is in the worst case scenario as it’s very rare to see a top performing Blue Chip, high liquid share ever to crash to zero.
So what can Tony do to make sure he only loses the R4,500 in his trade.
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There is a generally accepted misnomer in the financial sector that the numbers aren’t real, that there are no products behind them, no real money.
It’s as if they’ve forgotten that when you buy gold, you get a lump of physical gold to hide away in your shed.
That when you invest in corn futures, there’s an actual freight carriage full of corn sat in an industrial train yard somewhere, or in a farmer’s field, ready to be harvested.
And, that the currency markets determine the value of the sterling coins you carry around in your pocket every day.
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The best thing Tony can do to protect his portfolio from the worst case scenario
As soon as Tony buys his 100 CFDs, he needs to put in a strict stop loss.
By putting in a risk level, Tony will ensure that he’ll manage his risk so he only stands to lose what he’s willing to risk.
To calculate your stop loss, it’s linked to the price you get in at and the amount you’re willing to risk.
I always recommend to never risk more than 2% of your portfolio.
And so, Tony will have to choose between where he gets in and what he’s willing to risk to make sure he only risks 2% of his portfolio.
Three other important ways to manage your risk
Safety net #1:
Do not hold a position over the weekend as the market could gap first thing as it opens on a Monday.
Safety net #2:
Place a guaranteed stop loss on your CFD trade, which will get you out of the market at the stop loss you placed and the market maker will take the risk.
Safety net #3:
Feel free to call your broker and ask him to make sure he calls you if the market gaps his stop loss… Brokers nowadays are willing to help you in every way.
“Wisdom Yields Wealth”
Chief Analyst, Red Hot Storm Trader
If you have any trading questions that will help you achieve even greater trading success, feel free to ask me at the Forex 101 Workshop
. I’ll be in Johannesburg on Saturday the 10th
of September and Saturday in Durban on the 3rd
of September 2016. Book your seat now as places are running out.
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