Danger Ahead – CFD Trading!

Danger Ahead – CFD Trading!

Demystifying CFD trading: pitfalls and advantages

For many new investors and even seasoned investors, the words ‘contract for difference’ (CFD) or ‘derivative’ are enough to send them running for the hills. Derivatives are more risky than shares since you can gear your exposure but the risks can be managed and controlled. Derivatives have so many advantages that it would be irresponsible to ignore them, especially if you want to win the iTrade With A Million competition. Using the Sanlam iTrade risk-free virtual trading platform is an ideal way to gain experience in derivative trading.

What are derivatives and CFDs?

To keep it simple: a derivative is a tradeable instrument that derives its value from an underlying asset. Its value is directly linked to that asset. The asset can be a share, an index like the JSE Top 40 or a commodity like gold or oil. Futures and CFDs are two very similar types of derivatives. We trade only in CFDs since they are much easier to understand and the price is equal to the price on the JSE. Futures expire every three months and interest to expiry is calculated into the price. CFDs don’t expire, so you never pay roll-over costs.

For example, a Sasol CFD is directly linked to the share price of Sasol on the JSE on a one-for-one basis. If you buy 100 CFDs on Sasol for R100 each, you get the same exposure as an investor who bought 100 shares. However, you only have to put down a margin (deposit) of 10% or R1 000 compared to the full R10 000 you need to buy 100 shares. The CFD contract is that you will either get the difference between R100 and the market price when you exit the position if it is higher (profit), or you’ll pay in the difference if it is lower (loss). To prevent huge losses at the end, your position is margined every evening, which means you’re either paid (profit) or you pay (loss). Every evening there is also an interest deduction, since in effect you’re borrowing the 90% difference between the margin and the full share value. This is usually quite small.

The risk

If you have R10 000 and buy 100 shares at R100, your risk is no bigger than if you had bought the shares. It is exactly the same, your exposure is the same and your dividends will be the same. In essence, CFDs are therefore no more risky than shares.

The risk comes in with gearing. With your R10 000 you can actually buy 1 000 CFDs on Sasol, giving you an exposure of R100 000 on which the margin is the full R10 000 you have. This gearing means you will make 10 times more profit if Sasol goes up, but you will also lose 10 times more if the share price goes down. In fact, when Sasol goes down we will automatically start closing your positions. If Sasol falls overnight when the market is closed, you can lose more than your R10 000. This only happens in extreme market movements such as with Steinhoff in December 2017.

Mitigating the risk

The lesson is clear: don’t gear yourself more than the risk you are willing to take. If you gear yourself 3 or 4 times, you can easily ride through a patch where the share price goes down, since you will have sufficient funds to cover your daily margin calls.

You have to manage your CFDs more closely than long-term share investments. You should certainly enter a stop-loss order when you buy a CFD. Decide before you buy how much you are prepared to lose, enter a stop-loss order and stick to it. Your expected profit (reward) should be at least twice as much as the loss you are willing to take.

The major advantages trading CFDs

  • We’ve already discussed the advantage of gearing or leveraging your exposure a few times to increase the profits you can make. We’ve also looked at the risks involved in gearing. In a competition like iTrade With A Million, it will be hard to beat good CFD trades with direct equity trades.
  • One of the biggest advantages, especially in a choppy market such as we’re experiencing now, is that you can make profits if share prices fall. It’s called going short – you sell an instrument you don’t have and buy it back after the price has declined. Let’s say you start with only R10 000 cash in your portfolio. You read that OPEC will increase production, which could lead to falling oil prices. Instead of waiting for Sasol to fall before you buy for a bounce back, you can sell Sasol CFDs. Now you will make a profit if the share price falls. For example: you sell 300 Sasol CFDs at R100 each for a R30 000 exposure to the downside. The share price falls 10% or R10. You buy the CFDs that you sold at R100, back at R90. Your profit is R3 000 or 30% on your R10 000 portfolio, since you geared yourself 3 times. If the share price had gone up by 10%, you would have lost R3 000.
  • Another advantage is pairs trading: ‘Pairs of stock’ is a method used if a trader believes one stock will outperform another in a similar industry. The trader may feel Anglo will outperform Billiton, and thus buys Anglo and sells Billiton short. Because they are driven by much the same factors, you take out a lot of the market risk. It doesn’t matter if commodity shares in general go up or down, it only matters to you that Anglo performs better than Billiton.
  • CFD trading costs are usually cheaper than those for equities. Although you pay broking fees on your full exposure, the fee is in general 0.35% for CFDs compared to 0.5% for equities. There are also no JSE taxes or levies on CFDs. With equities, you will pay an extra 0.25% securities tax on all purchases. This makes quite a difference if you are trading actively.
  • A word of caution when choosing a CFD provider, however: CFDs are not regulated by the JSE, which means there is no JSE guarantee if a CFD provider goes bankrupt. If your CFD provider goes under, you could lose everything – this has happened both in SA and overseas. With Sanlam iTrade you are backed by the huge Sanlam balance sheet.

This, in a nutshell, is what CFDs are all about. Try a few strategies on our risk-free demo or virtual trading platform. Enjoy!

Gerhard Lampen

Head: Online Trading

Sanlam Private Wealth

*Also try out our virtual trading competition!

 

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