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Spread Trading

An introduction to  Spread Trading

 

Spread Trading allows you to profit from the movement of a financial instrument, up or down, without having to to take ownership of the asset.

 

Put simply, it provides a platform to trade in the high-risk futures market with less financial outlay or risk than if you had purchased the instrument (equity, commodity etc), with but greater potential for profit and faster returns.

 

So, how does it work...?

 

Example

 

1) PROFITING FROM A RISING SHARE

 

Lets assume you think Telkom shares are going to increase in value in the near future. You would place a "buy" trade on Telkom at say R 1 per point (a point is equal to 1 cent on equities). The Spread Trading company require a deposit (margin) to place this trade.  In this case the margin would be R850.00 (this is your total investment liability). If Telkom's price was R 104.93 at the time of placing this trade and it rose to

R108.00 one week later this would constitute a 307 point move in your favour at R1  per point: an impressive 36% return on your money at R307.00 on an initial outlay of R850.00.

 

2) PROFITING FROM A FALLING SHARE.

 

If you think Telkom shares are going to fall in price you can profit from exactly the same movement but in a downward direction. You would then place a "Sell " order with the Spread Trading company at R1 per point. The margin requirement would be exactly the same and you would profit at R1 per point for every cent that Telkom's  share price dropped.

 

Stop Losses

 

One of the most user-friendly features of Spread Trading is that you can set a pre-determined risk level before placing your trade.  In other words you limit the amount of money you are prepared to risk if the trade goes against you in advance. Using the above example, lets say you bought Telkom to rise in value at R 104.93 FOR R1 per point. The Trading company will either ask you for a STOP LOSS level or will automatically set it for you. Your margin is R850-00, BUT you are only prepared to risk losing R400-00 on this trade. Therefore your stop loss will be set at (R104.93 entry price - 400 points (400 cents) = R100.93).

 

Should this trade go against you, as soon as the share price drops to R 100.93 your trade will be closed out, your loss of R400.00 will be deducted from your margin and the balance of R450.00 will be returned to you.

 

The Stop loss strategy is the most important factor in successful trading as it allows you to minimize your losses and preserve your capital for future profitable trades.

 

Spread Trading verses Equity Trading

 

Applying a geared method like Spread Trading has a number of advantages over traditional trading methods which require ownership of the underlying asset.

 

As there is no asset purchase you don't need a broker to make trades on your behalf so there are no broker fees or broker interventions on your activity.  There are also no extra levies such as MST, ITL, Strate or VAT.  Low execution cost means tight spreads can be more profitable than regular futures trading.

 

Investors buy or sell contracts which reflect an asset’s underlying price and only have to put up a fraction of the contract to carry a trade though. The profits and losses of a Spread Trade mirror the performance of the underlying asset.

 

The profit (or loss) comes from  the difference between the opening and closing contract prices

 

Example: Spread Trade vs. Equity Trade

 

  Trading Method

Spread Trade

Equity Trade

  Purchase

R1 per point

margin = R656

100 shares = R7040

 

Brokerage + Costs

NO Brokerage

NO Extra Costs

Brokerage1% = R70.40

MST 0.25% = R17.60

Strate = R10.60

ITL =R0.05

VAT = R13.81

 

Telkom price on

19/05/2004

7541 – 7594

7560 – 7575

 

Capital realised

R656 + (482 x 1R)

= R1138

R7560
 

Selling Costs

NO COSTS

Brokerage 1% = R75.60

Strate = R10.60

ITL = R0.05

VAT = R12.08

 

Profit realised

R482

R309.21

 

Return on Capital

73%

4.3%

 

 

This is a basic overview.  You can access more detailed information on successful Spread Trading strategies by registering with us (for free) here.

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