DINEO TSAMELA: And now for the risks and rewards of contracts for difference
Over the past few weeks, in an effort to assist you on your trading journey and help you to avoid scams, we've been looking at forex trading.
This week we turn our attention to another trading instrument: contracts for difference.
CFDs are contracts of agreement between a buyer and a seller. Traders can take advantage of the movement of underlying assets without owning the actual shares. For instance, if traders think that a particular share price is going to go up, they can take a long position and make a profit off the movement of the underlying asset.
In effect, the trader is borrowing stock from the broker in order to take a position. The broker supplies the underlying asset - and in return will claim commission in the form of fees.
The cost of trading CFDs is lower than the cost of buying a share. Compare costs across brokers to get the best deal. Typical costs will include brokerage, tax and statutory fees such as for Strate - which owns the technology to safely keep equities, bonds and money market securities in electronic form.
In times of uncertainty you may want to use CFDs to hedge your position. Hedging allows you to balance your portfolio so you can protect your investments against unexpected or adverse market movements.
Say you own shares in company X and you anticipate the shares will decline due to a significant event affecting the company. You can take a short position on the share and make a profit on the decline - without having to sell the shares you hold.
But you can also use CFDs for speculative reasons. If you believe a share will go one way and simply want to make a profit off that movement, you could trade CFDs.
Much like forex trading, trading CFDs enable investors to take advantage of leverage or gearing.
Gearing allows the trader to put down only a little money but get the benefit of the full price movementwithout having to own a share.
Where a shareholder may pay R300 to own a share, a CFD trader can put down R100. If the share price moves to R310, the shareholder will make a R10 profit - or 3%. The CFD trader, on the other hand, will make a 10% profit.
However, the opposite also applies. Long-term investors probably won't be shaken too much if a R300 share falls to R290, but a CFD trader will make a very large loss, depending on how much they're geared.
CFD traders can take a short position on shares. This means they're expecting a share to lose value and want to make a profit off that downwards movement.
Not every share will be available for you to take a short position. It depends on how volatile the share is.
Shares that are traded frequently usually qualify for CFD trading, but how that is determined may differ from broker to broker. Your broker should have a list of shares that they consider eligible for taking a short position.
As with any trading product, CFDs also carry a lot of risk. If you make the wrong bet, your losses are exaggerated and you will be liable for the loss to the broker you choose.
Choosing a platform to trade CFDs should be treated with the same due diligence you'd apply if you were trading shares or forex - don't simply go with the first thing that pops up on your Google search. You need to be sure that you broker is well known and that it is easy to access information about them.