How Gearing Works with CFDs and Spread Trading

This is the most important concept you’ll need to understand to accelerate your account.

During your trading experience, with gearing, you’ll learn how to multiply your profits. But you can also multiply your losses, if you don’t know what you’re doing.

So listen up.

What Gearing is in a nutshell…

Gearing also known as leverage or margin trading, is the function that allows you to pay a small amount of money, in order to gain control and be exposed to a larger sum of money.

There is a very simple calculation you’ll use calculate the gearing for both CFDs and Spread Trading.

• Exposure
  Initial margin
  

In order to understand this formula, let’s use three gearing examples with shares versus CFDs and Spread Trading.

We’ll break it up into three steps for CFDs and Spread Trading:

1. Calculate the entry market exposure
2. Calculate the initial margin (Deposit)
3. Calculate the gearing

We’ll also exclude costs to help simplify the gearing concept better.

EXAMPLE 1:

Buying AAS Ltd shares
Portfolio value: R100,000
Company: AAS Ltd
Share price: R109.00
No. shares to buy: 100

If you buy one share at R109 per share, you’ll be exposed to R109 worth of one share.

If you buy 100 shares at R109 per share, you’ll be exposed to R10,900 worth of shares (100 shares X R109 per share).

We know that to be exposed to the full R10,900 worth of shares, we needed to pay an initial margin (deposit) of R10,900.

If we plug in values into the gearing formula, we get.

Gearing = (Exposure ÷ Initial Margin)
= (R10,900 ÷ R10,900)
= 1:1

This means, there is NO gearing or a gearing of 1 times, with the share example as, what we paid is exactly as what we are exposed to.
Easy enough? Let’s move onto CFDs.

EXAMPLE 2:
Buying AAS Ltd CFDs

Portfolio value: R100,000

CFD of the underlying Company: AAS Ltd CFD
Share price: R109.00
Margin % per CFD: 10%
(NOTE: Find out on your trading platform or ask your broker for the margin % per CFD)
No. CFDs to buy: 100

Step #1:
Calculate the entry exposure of the CFD

Entry exposure
= (Share price X No. CFDs)
= (R109.00 X 100 CFDs)
= R10,900

NOTE:
1 CFD per trade, you’ll be exposed to the value of one share.
100 CFDs per trade, you’ll be exposed to the value of 100 shares.

Step #2:
Calculate the initial margin of the CFD trade

Initial margin
= (Exposure X Margin % per CFD)
= (R10,900 X 0.10)
= R1,090
This means to buy 100 CFDs, you’ll need to pay an initial margin (deposit) of R1,090.

Step #3:
Calculate the gearing of the CFD trade

Gearing = (Exposure ÷ Initial margin)
= (R10,900 ÷ R1,090)
= 10 times

With a gearing of 10 times, this means two things…

#1: For every one CFD you buy for R10.90 per CFD, you’ll be exposed to 10 times more or the value of one AAS Ltd share.

#2: For every one cent the share price rises or falls, you’ll gain or lose 10 cents.

EXAMPLE 2:
Buying AAS Ltd CFDs

Portfolio value: R100,000
Underlying Company: AAS Ltd
Share price: 10,900c
Value per point: 100c (R1.00)
Margin % per Spread Trading contract: 7.50%

(NOTE: Find out on your trading platform or ask your broker for the margin % per share contract)
Step #1:

Calculate the entry exposure of the spread trade

Entry exposure

= (Share price X Value per point)
= (10,900c X 100c)
= 1,090,000 (R10,900)

Note:
1c value per point per spread trade– you’ll be exposed to one AAS share
100c value per point per spread trade – you’ll be exposed to 100 AAS shares

Step #2:
Calculate the initial margin of the spread trade
Initial margin

= (Exposure X Initial margin)
= (1,090,000c X 0.075)
= 81,750c (R817.50)

This means, you’ll need to pay an initial margin (deposit) of R817.50 to be exposed to R10,900 worth of AAS Ltd shares.

Step #3:
Calculate the gearing of the spread trade
Gearing = (Exposure ÷ Initial margin)
= (1,090,000 ÷ 81,750c)
= 13.33 times

This means, by depositing R817.50 you’ll be exposed to 13.33 times more or R10,900 (R817.50 X 13.33 times) worth of AAS Ltd shares.
You now know how gearing works with CFDs and Spread Trading, in the next lesson we’ll cover how to never risk more than 2% of your portfolio for each CFD and Spread Trade you take.