*** The best trading tool for you...

*** Weighing up your options...

*** How to get started... and more...

From the desk of Julie Brownlee

Dear Investment Academy reader,

2009 has kicked off with continued mayhem on the markets; the JSE is bouncing around daily. The general view from analysts is this extreme volatility is likely to continue for now and a recovery on the markets probably won't emerge until the second half of the year at the earliest.

So where does that leave you and your investments? Well, if you have a very long-term view of investing, now may be the ideal time to start buying up some blue-chip bargains. But, if your investment horizon is shorter, trading may offer you an excellent way to profit from the market's bounces. But, a word of warning: Trading is risky and you shouldn't consider jumping into this realm unless you know what you're doing and you're well aware of the risks you're undertaking.

Now with the health warning out the way, let's explore the opportunities on offer to you through trading contracts for difference (CFDs)...

What trading instrument suits you?

Spread trading, trading futures and buying shares directly are the most common ways for private investors to trade the markets. But another option worth investigating are CFDs – a tool that’s been around for some time, but has become much more accessible and easy to trade with the rise of online broking and companies offering CFD trading.

As the name suggests, CFDs are a contract between two sides – the buyer and the seller – where the seller agrees to pay the buyer the difference between the price of an asset at the time the contract begins and the time at which it's closed. (If the difference is negative, the buyer pays the seller.)

So, if you buy a CFD on Absa at R90 and the price rises to R91, the seller would have to pay you R1 per share. If it fell to R89, you'd have to pay the seller R1.

Gearing up to boost your returns

CFDs generally have no fixed expiry date (unlike futures and spread trading) and can be closed at any time. Like spread trading and futures trading, they're a margined product, meaning that you only have to put up a percentage of the face value of the contract at first. The margin's typically 5% to 25%, depending on the asset that the CFD's based on. This means that, like spread trading, you can make much bigger gains relative to the amount of money you have to put up compared to trading shares directly.

In our Absa example above, if the margin requirement is 5%, you initially have to put up R4.50/share (5% x R90). If the share rises R1, you make a return of 22% on your initial stake (R1/R4.50). That compares with a return of 1.1% (R1/R90) if you bought the shares directly. Of course, you can also make bigger relative losses – a fall of 5% (R4.50) in the share would completely wipe out your margin. So you need to be disciplined about cutting trades that go wrong and use stop losses.

Like spread trading and futures trading, CFDs are best suited to shorter-term trades (measured in fays and weeks rather than months). Although the contracts are open ended, you have to pay a daily financing cost (referred to as funding) to keep the position open (this is essentially the interest on the money you’ve borrowed from your provider by putting up, say, 5% in margin) and, over time, this mounts up and eats into your returns.

CFDs vs. spread trading and futures trading

So are CFDs a better alternative to spread trading or futures trading? Well, that depends on your level of experience and how often you intend to trade. For the beginner or the relatively infrequent trader, the answer is no. Minimum account and trade sizes mean that spread trading is a much better way to get started when compared to CFD and futures trading. However, if you’re a frequent trader, it may be worth considering moving onto CFDs.

Firstly, although you'll be charged commission on CFD trades, this may work out cheaper than a comparable spread trade, depending on how tight the bid-offer spread is from your spread trading company. Secondly, you may find it easier to manage your risk using CFD trading, as most platforms will automatically exit you from the trade at your predetermined stop loss when compared with futures trading, where you normally have to phone through to exit your trade. Finally, if you buy a CFD on a share and the share pays a dividend while you hold the CFD, the seller will owe you the amount of the dividend. With a spread trade, for instance, you don't receive the dividend. But remember, if you sell (short) a CFD on a share that pays a dividend, you have to pay the dividend.

How to start trading CFDs

Many of the big banks in South Africa now offer CFD trading, along with other companies and stockbrokers. There’s an abundance on offer out there, so check out the spread on offer, and associated fees and costs to find the best deal for you.

That's all from me for this week. Karin will be back on Monday with a personal finance goody for you. Till next Friday...

Happy trading!

Julie Brownlee
For the Investment Academy