know your instruments of gearing

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    From Today's AFR. Gearing 101 for anyone who's leveraged. (I'm hoping copying is the best form of flattery, rather than a breach of copyright...)

    Know the instruments of gearing
    Aug 02
    John Wasiliev

    Do you know your margin loan from your contract for difference? Your protection from your internal gearing? It's essential to understand the terms and definitions that apply to the main strategies available for gearing. Like any financial sector it's afflicted by jargon, and the consequences of misunderstanding what you're invested in can be drastic. Here is a potted guide to the most common instruments:

    Margin lending

    A geared arrangement where investors can borrow up to 70 per cent of the market value of chosen share investments. The investor puts up the balance. With margin loans, the main security is the investments plus an investor's promise to "top up" the difference if the value of the investment falls below certain levels. Margin loans are usually interest only.

    Instalment gearing

    A margin loan arrangement that is linked to a regular savings plan. The investor makes an initial investment of their own money plus some borrowed funds. Afterwards, as more money is saved, this is matched by borrowed funds and used to make further investments. An instalment gearing strategy is often combined with the strategy of dollar cost averaging, where regular amounts are invested regardless of prices. It is also often used to build up an investment in a managed fund.

    Protected loans

    A structured investment where a loan amount is protected by a derivative, specifically a put option that provides security in the event of the value of the underlying investments collapsing.

    Internally geared managed share funds

    A share fund where the fund borrows to gain the advantages of gearing.

    Instalment warrants

    A structured investment that is basically a packaged loan over shares, where the repayment of the loan is optional and where all dividends and franking credits are passed through to the investor. Instalments can be attractive for DIY super funds, providing gearing and tax benefits while still complying with superannuation regulations.

    Warrant and option trading

    You don't need to borrow money to have a "geared" investment, says lawyer Bill Fuggle, a derivative expert with Baker & McKenzie in Sydney. A warrant or option will give you leverage over shares or an index contract. You pay a small premium relative to the value of the underlying investments and if the price moves as you expect, the reward can be a handsome profit. If it doesn't move, the worst you can lose is the money you put in.

    Contracts for difference (CFD) trading

    A CFD is basically share trading on margin where the profit or loss comes from the difference between the price at the opening of the trade and what is being quoted when a position is closed out. Investors buy the share CFDs on the same spread as shares on the Australian Stock Exchange. With CFDs, traders are dealing directly with the organisations that promote them.
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