Have you ever wondered what the widely used term ‘contract for difference’ means?
More importantly, how do they work?
Contracts for difference (CFDs) have the power to take your trading, and your profits, to the next level!
But only if you know how to use them properly…
That’s why today I’ll show you how to improve your investment portfolio using CFDs.
How a CFD works, and how it can work for you!
A contract for difference (CFD) is a contract between two parties, usually between a “buyer” and a “seller”, which stipulates that the seller will pay the buyer the difference between the current value of an asset and its value at contract time.
CFDs are financial derivatives on an underlying asset (without the trader ever taking ownership of the underlying asset).
Examples of these underlying assets can be equities such as the top 40 companies that trade on the JSE.
A contract on equity derivatives allows traders to take advantage of share prices moving up (Long positions) and prices moving down (Short positions) on the underlying asset.
Why you need to add CFDs to your trading toolkit
Most people trade CFD’s for the following reasons:
Reason No 1: Leverage
One of the biggest benefits of trading CFD’s is that they are traded on margin, meaning that they provide the investor with leverage.
Leverage involves taking a smaller deposit and using it as a lever to borrow and gain access to a larger quantity of assets.
Basically you can put down a smaller ammount in order to gain control of a much larger ammount.
Reason No 2: Speculating
If you want to take advantage of short-term movement in a specific share without taking physical ownership of the asset CFD’S are used.
Long and Short positions can be taken on equities which brings us to our following reason
Reason No 3: Hedging
Making an investment to reduce the risk of adverse price movement in an asset. Usually a hedge consist of taking an offsetting position in a related share, using CFD’s
Suppose you hold a specific share in your investment portfolio, by hedging yourself you would take a “Short” CFD position on this specific share.
Going short means that you are selling shares in the market – remember that you are not taking physical ownership of the asset when trading CFD’s – and should you buy them back at a lower price, profit will be made between your selling price and the price you bought them back (the difference) and similar a loss will be made should you buy them back at a higher price.
The nuts and bolts behind a CFD trade
Here’s an example of a CFD trade:
Lets say you want to purchase MTN shares that are trading at R200.00 per share.
If 100 MTN shares were bought at R200.00 the cost to the investor would be:
100 x R200 = R20,000
With CFD’s you’re only required to put down a margin to hold the position determined by the CFD provider.
The Margin requirement on MTN is 10%.
Thus R20,000 x 10% = R2,000 margin to hold 100 MTN’s.
Now, say the share price moves to R220 per share and you sell you made a profit of R20 per share.
R20 x 100 shares = R2,000 profit.
(R,2000/ R20,000) x 100 = 10% profit if you purchased this as normal equity, but you were only required to place a margin of R2,000 and thus
(R2,000/R2,000) x 100 = 100% profit was made on initial margin.
Using the same example say MTN share price moves down from R200 to R190 where you sell your position.
This means you would incur a loss of R10 per share:
R10 x 100 shares = R1,000 loss
(R1,000/R20,000) x 100 = 5% loss on normal equity
The loss on margin that you placed on the CFD would be:
(R1,000/ R2,000) x 100 = 50%
Always remember: CFDs leverage your position, and thus increases your potential reward as well as your risk.
How to start trading CFDs today
Contract for differences can be great for your portfolio and your performance if you use them correctly.
So, if you’re looking to take advantage of short term movement in share prices, or you’re scared of a short term correction in the market, use CFDs as an alternative to buying and selling your long term investment holdings.
My team and I at Vunani Private Clients specialize in CFD trading, and we look after and help hundreds of our clients in trading CFDs.
If you want to start trading CFDs today, and use them to improve your investment portfolio get in touch with me!
Here’s to profitable trading.
Private Client Trader | Vunani Private Clients
011 384 2922