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Understanding Gearing

 Gearing, also referred to as leverage, is the use of a financial instrument or borrowed funds to gain a large exposure to a share (or any asset) with a small amount of capital. Gearing is used by traders and investors to try and magnify gains. Gearing is unfortunately a double edged sword, both profits and losses are magnified. When one decides to trade derivatives, they will inherently be making use of gearing.

 

When talking about gearing it is important to understand some of the terminology around margin, more specifically Initial Margin (the initial deposit for the geared position) and variation margin (the amount of money required to maintain the initial margin balance daily)

 

To help you understand how gearing works, think about what happens when you buy a house. It’s unlikely you have all the money you need to buy a house outright, so you borrow money from the bank to make up the difference, for example: Say you buy a house for two million, the bank will require a deposit of say two hundred thousand, as such the investor is giving the bank a small deposit (initial Margin) to gain exposure to a much larger asset.

 

CFDs allow an investor or trader the ability to gain exposure to shares while only putting down a small amount of capital. For example, if XYZ share price is R100.00 per share, investors in CFDs are able to buy 1 XYZ CFD, with as little as R10.00 or 10% of the share’s value. While this positions them to multiply any improvement in XYZ’s share price by ten, it also means that their exposure is R100.00, not the R10.00 or 10% that they put down. In other words, while only putting down a deposit of R10.00, in a worst case scenario you could lose more capital than you put down.

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