Most of us have heard of leverage. Anyone who has ever had a home loan knows the benefit of borrowing money to buy your own home when you haven’t got the capital to buy it yourself. Trading with CFDs (Contracts for Difference) is a similar principle.
Trading is defined actively buying and selling shares or derivatives to profit from price changes in the market. CFDs offer a more affordable way to enter these trades as the trader is only required to put forward a percentage of the full value of the shares. A Contract for Difference means your broker will give you access to the price change (or Difference) in a stock for a percentage of the cost of the actual share. Let’s look at an example:
Chart 1: Recent Trade on Santos
click to enlarge
Chart 1 shows a recent trade on Santos. For $20,000 we could buy about 1,500 shares at an entry price of $12.79. Using CFDs with a margin of 8% (based on optionsXpress margin requirements) we could buy more than 19,000 CFDs. We wouldn’t typically tie up all our capital in one trade but let’s compare the profits.
Buying at $12.79 and selling on the market open after the 100% milestone was hit would give a profit of $13.40 - $12.79 = $0.61 per share. If we traded 1,500 shares outright, this would give us a profit of $915. If we used leverage on the same amount of starting capital, our 19,000 CFDs would give us a profit of $11,590.
It is important to note that you will pay interest for using the CFD product, just as you would with a home loan. This is calculated using the base cash rate plus a margin to line the broker’s pocket! As a percentage of profits, the interest cost is usually insignificant. On the other side of the ledger, if you are in a short trade (you are selling the CFDs), you actually receive interest at the cash rate minus a margin.
To illustrate, when we buy our 19,000 CFDs of STO at $12.79, the value of the transaction is worked out as 19,000 x $12.79 = $243,010. Using a base rate of 4.5% p.a. we would pay approximately 4.5%/365 x $243,010 for each day that we held the position, which works out to approximately $29.96 per day for the four days we were in the trade. As a percentage of the $11,590 profit, this is insignificant.
The numbers will vary depending on the size of the trade and the stock but the lesson is the same. The benefit of CFDs is that you have exposure to the full movement of a stock price for a fraction of the trade value. This means you can afford to have several trades or take bigger positions than you would otherwise be able to with your capital. It is making your money work for you.
It’s the Journey