EXPLAINED: Gearing and how it worksThere is one tool with trading, which you can accelerate your portfolio, compared to with investing.
I’m talking about Gearing (or leverage).
To wrap our head around this concept, here’s a more relatable life example.
When you buy a house for R1,000,000, it is very similar to trading derivatives. Initially, the homeowner most probably won’t have the full R1,000,000 to buy the house with just one purchase.
Instead, they’ll sign a bond agreement, make a 10% deposit (R100,000), borrow the rest from the bank and be exposed to the full purchase price of the home. This is a similar concept for when you trade with gearing.
Gearing is a tool which allows you to pay a small amount of money (deposit) in order to gain control and be exposed to a larger sum of money.
You’ll simply buy a contract of the underlying share, use borrowed money to trade with and be exposed to the full share’s value.
Let’s simplify this with a more relatable life example:
How gearing works with CFDs
Let’s say you want to buy 1,000 shares of Jimbo’s Group Ltd at R50 per share as you believe the share price is going to go up to R60 in the next three months. You’ll need to pay the entire R50,000 to own the full value of the 1,000 shares (R50 X 1,000 shares).
In three months’ time, if the share price hits R60 you’ll then be exposed to R60,000 (1,000 shares X R60 per share).
Note: I’ve excluded trading costs for simplicity purposes throughout this section
If you sold all your shares, you’ll be up R10,000 profit (R60,000 – R50,000). The problem is you had to pay the full R50,000 to be exposed to those 1,000 shares.
When you trade a geared instrument like CFDs, you won’t ever have to worry about paying the full value of a share again.
A CFD is an unlisted over-the-counter financial derivative contract between two parties to exchange the price difference of the opening and closing price of the underlying asset.
Let’s break that down into an easy-to-understand definition.
A CFD (Contract For Difference) is an
Unlisted (You don’t trade through an exchange)
Over The Counter (Via a private dealer or market maker)
Financial derivative contract (Value from the underlying market)
Between two parties (The buyer and seller) to
Exchange the
Price difference of the opening and closing price of the
Underlying asset (Instrument the CFD price is based on)
Let’s use an example of a company called Jimbo’s Group Ltd, who offers the function to trade CFDs.
The initial margin (deposit) requirement is 10% of the share’s value. This means, you’ll pay R5.00 per CFD instead of R50, and you’ll be exposed to the full value of the share.
To calculate the gearing (or leverage ratio) you’ll simply divide what you’ll be exposed to over the initial margin deposit.
Here’s the gearing calculation on a per CFD basis:
Gearing
= (Exposure per share ÷ Initial deposit per CFD)
= (R50 per share ÷ R5.00 per CFD)
= 10 times gearing
This means two things…
#1. For every one Jimbo’s Group Ltd CFD you buy for R5.00 per CFD, you’ll be exposed to 10 times more (the full value of the share).
#2. For every one cent the share rises or falls, you’ll gain or lose 10 cents.
To have the exposure of the full 1,000 shares of Jimbo’s Group Ltd, you’ll simply need to buy 1,000 CFDs. This will require a deposit of R5,000 (1,000 CFDs X R5.00 per CFD).
With a 10% margin deposit (R5,000), you’d have the exact same exposure as you’d have with a conventional R50,000 shares’ investment.
Here is the calculation you can use to work out the exposure of the trade.
Overall trade exposure
= (Total initial margin X Gearing)
= (R5,000 X 10 times)
= R50,000
With an initial deposit of R5,000 and with a gearing of 10 times, you’ll be exposed to the full R50,000 worth of shares.
In three months’ if the share price reaches R60, your new overall trade exposure will be R60,000 worth of shares (1,000 shares X R60 per share). If you sold all of your positions, you’d bank a R10,000 gain (R60,000 – R50,000).
But remember, you only deposited R5,000 into your trade and not the full R50,000. This is the beauty of trading geared derivative instruments.
If you want any other technical trading or fundamental term explained, please comment below. I'm happy to help.
Trade well, live free
Timon
MATI Trader
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