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What is a CFD?

Contracts for Difference (CFDs) can be hard-working additions to any portfolio. They provide a way to hedge out the risk a portfolio is exposed to as well as to speculate when the belief is that the price of a share will change.

CFDs provide investors with the ability to gear (leverage) their investment, while avoiding many of the costs of trading in the underlying instrument. Long or short trades can be executed easily and cost-effectively.

 

What is a CFD?

A CFD is an unlisted, over-the-counter(OTC), instrument that is an agreement between a buyer and a seller to exchange the difference in value of a particular instrument for the period between when the contract is opened and when it is closed. The difference is determined by reference to an underlying instrument for the period that the CFD is held. If this all sounds a little complex a simple example bleow should clarify this.

 

CFDs are leveraged instruments. This means that you are fully exposed to price movements of the underlying instrument without having to pay the full price of that instrument. You are only required to put down a percentage of the full value of the purchase, this is known as initial margin.

 

CFDs therefore offer the potential to make a higher return from a smaller initial cash outlay than investing directly in the underlying instrument. Leverage, involves more risks than a direct investment in the underlying instrument. It is important to understand that this effect may work against you as well as for you – the use of leverage can lead to large losses as well as large gains.

 

Who are the participants?
With exchange traded (listed) derivative products the holders of positions have added security in terms of legislation as the exchange becomes the counterparty to the transaction to ensure that holders comply with their rights and obligations. SBSA CFDs are OTC instruments (not exchange traded) and as such do not offer you the protection that some listed products may offer, that is you rely solely on SBSA making good on its obligations (you have counterparty risk to SBSA) instead of an exchange.

 

A Simple Example:

Trader A is an equity trader, and Trader B is a CFD trader. They both have the same view of the market and belive that share XYZ will increase in price.

 

Trader A

• Trader A is confident that XYZ Limited shares are set torise.

• R50 000 cash is available.

• The share price is R100, so 500 shares are bought.

• Two months later, the price is R106,75, the trader sells and so makes R3 375 profit (R6,75 per share multiplied by 500 shares) a return of 6,75%.

Trader B

• Trader B takes the same view but buys CFDs rather than the shares.

• The underlying shares price is R100 and Trader B wishes to have R50 000 worth of exposure to the share

• The only cash required to enter into the trade and purchase the CFDs is the Initial Margin amount of R7 500

• This gives Trader B R50 000 exposure to the underlying shares.

Two months later, the price of the underlying share is R106,75, the trader sells and so makes R3 375 profit (R6,75 multiplied by 500 CFDs)

• This is a return of 45% of the amount invested, seven times the profit made by trader A.

 

This has been a very brief introduction into the mechanics of how a CFD works and what its potential advantages are.

 

There is a great video on the product and how it works which can be found here.

You can also take a look at out brochure to find out more information about CFDs

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