For the retail market, investing in the sharemarket mainly consisted of one type of share investing, that is, calling your stock broker, buying shares in the opinion (belief or even hope) that the price will rise and then calling your stock broker when you decide to sell the shares. Hopefully the share price rose and you would have made a profit. However the avenues available to investors and traders have increased over the last few years. Products such as margin lending, CFDs (Contracts for difference),
Exchange Traded Options (ETO's) and instalment warrants have increased the type of strategies and investment opportunities available to the retail market. The increase in product range has likewise caused some confusion amongst retail investors. In this discussion, we will comparing CFDs with margin lending.
CFD
CFD stands for Contract for Difference. CFDs are an equity derivative that are traded over the counter (they are not traded on an exchange) and allow retail investors to trade on fluctuations in the share price without having to own those shares.
How do CFDs work?
CFDs allow you to take long or short positions in a stock without having to physically purchase the underlying security. A long position is taken when you are of the opinion that the stock price will rise, while a short position is taken if you think the price will fall.This flexability is fantastic for short term trading.
Once you have taken an opinion (long or short) on a particular stock you will then place you order through your provider. They inturn will offer you leverage which will allow you to take a position in that stock for a lot less capital than purchasing the shares. The leverage amount can vary from provider to provider and from stock to stock. Basically, for the larger stocks that have greater liquidity you will be offered a greater leverage than you would for a smaller cap stock with less liquidity.
For example, for CBA shares a provider might offer you 20 times leverage. This means that for $1000, you can open a position worth $20,000. Assuming you went long, and the $20,000 was now worth $21,000 (5%) you would receive from your initial investment $2000 (100% return), less fees and charges, as compared to the $21,000 you would receive if you invested $20,000 in the actual shares through a broker.
The leverage amount can vary from 5 times to even 100 times leverage, however, if you are relatively new to trading CFDs it is recommended that you paper trade until you gain greater experience in the market. CFD providers 'fix' the leverage applied to individual shares and it is up to you to take it or leave it.
It should be pointed out that if the market moves against you, your losses will be leveraged higher as well. Furthermore, with CFDs you can actual lose more than you initially invested thereforer it is imperative you have an understanding of the stock market and things like leverage, stop losses and gapping. There are other weaknesses of CFDs that we cover in more detail
here.
Margin Lending
Margin lending is essentially borrowing money to invest in the sharemarket. Basically, with some of you initial savings you can borrow money from an institution (most likely a bank) and use this to purchase shares using the actual shares as collateral.
Margin Lending is similar to CFDs in some respects, that is, you can use leverage to increase your returns (or losses) but there are some key diferences. You can only use margin lending to purchase the actual shares and you cannot go short. The amount of money you are allowed to borrow varies with each share (or managed fund). You are however the owner of the shares, and as such are entitled to the Dividends and franking credits, you can also use the shares to generate premium through the use of some
option strategies.
How does Margin Lending work?
With the use of margin lending if the market falls you might need to provide extra money to the financial institution you have borrowed money from, this is called a margin call. Lets assume you have provided $20,000 and borrowed $80,000, that is, you now own $100,000 worth of shares. If the share price goes up then you have no problems, however, if the $100,000 goes down by 20% to $80,000, then the ratio of loan to share value becomes 100%. A margin call will be made to put the ratio back to 80%, this amount will be $16,000. If you are unable to provide the necessary funds the financial institution you have borrowed money from will sell enough of your shareholdings to maintain this percentage. A margin call will need to be provided for usually within 24 hours.
Margin lending suites people who are looking for medium to long-term investment opportuinites, it's best not to gear yourself up to the maximum level and you must have access to extra cash in case a margin call is required.