Trading uncovered: What is gearing?

Julie Brownlee, Fsp Invest, 02 Dec. 2014

Tags: gearing, what is gearing, trading, geared trading, how gearing works, leverage,

What makes trading different from investing is you make use of geared instruments.

So what is gearing? And how does it work?

Let’s take a closer look…

How does gearing work?

Gearing (or leverage) is using borrowed money to trade with. When you trade single stock futures, contracts for difference (CFDs) and spread trading, you’re using geared products.

A simple way to understand how gearing works is to think about what happens when you buy a house.

Say you buy a house for R1 million. You don’t have R1 million in cash to buy the house outright, so you put a deposit down and borrow the rest from the bank.

By putting down a deposit you gain control of a much larger amount of an asset.

This is exactly how gearing works when you trade.

Depending on the instrument you trade and what you trade, the amount of gearing you can get will vary.

Let’s look at how gearing works with contracts for difference (CFDs) as an example…

You want to trade Company ABC. You think its share price is going to rise in the short-term and want to take advantage of this move higher using CFDs.

Gearing in action

You decide to buy 1,000 Company ABC CFDs. This gives you exposure to 1,000 Company ABC shares.

If the share is trading at R38, your overall exposure is R38,000 (R38 x 1,000 CFDs).

Because CFDs are geared instruments, you put down a percentage of this amount. This is the margin (deposit).

If the margin requirement is 10%, to open the trade you’d put down R3,800 (10% of R38,000). This means you’re 10 times geared (R38,000/R3,800).

In other words, for every cent the share moves up or down, you’re gaining or losing 10c.

It’s gearing that multiplies your profits and losses when you trade.

So there you have it, what gearing is.

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