FinancialQuotient

What is 'contra trading'?

WHAT DOES IT MEAN?

Contra trading involves buying and selling the same shares without paying for them.

Most brokerages here do not require you to deposit cash with them before buying a stock.

But after a transaction, investors are given three days - known as the contra period - to transfer the cash to the brokerage as payment for the shares.

If an investor sells the shares before the end of the contra period, the trades will be offset by the brokerage. The investor will be paid any profits made from the trades. However, if he has incurred losses, he will have to pay the brokerage.

Investors must be careful that they do not buy more shares than they can afford, as losses can be heavy if the market moves against them. So contra can be a dangerous activity when there is a sudden, unexpected market movement and you do not have sufficient funds to pay for your transaction.

This buying and selling of the stock within the three-day period is known as contra trading.

Let's say you bought 2,000 shares of company ABC at $5 apiece on Monday, which is known as T+0. That is a paper cost of $10,000. By Thursday - three days after Monday or T+3 - you would have to sell those 2,000 shares.

Assume you sold them at $5.30 by T+3. That is a total of $10,600 giving you a profit of $600 before fees and charges.

You also do not need to stump up cash of $10,000 to pay for the shares.

However, if you sold the 2,000 shares at $4.80, you would have to pay for the losses as your selling price is lower than the purchase price. So your loss before brokerage fees in this case is $400 ($10,000 - $9,600).

In most other countries, investors have to have cash deposited upfront with their brokers or they would need to settle the full payment within a shorter period after the purchase.

WHY IS IT IMPORTANT?

Many traders use contra trading to take punts on shares without putting money upfront but this can be very risky.

Investors must be careful that they do not buy more shares than they can afford, as losses can be heavy if the market moves against them. So contra can be a dangerous activity when there is a sudden, unexpected market movement and you do not have sufficient funds to pay for your transaction.

Using the earlier example, let us assume that on T+3, the price of company ABC suddenly plunges to $2 and you have no choice but to sell your 2,000 shares at this price.

That would make a total of just $4,000 - and a loss of $6,000 from the initial $10,000 investment. Quite a chunk of cash (that is, $6,000) to have to fork out.

If you want to use the term. Just say: "The stock is for contra trading. Don't buy and hold."

A version of this article appeared in the print edition of The Sunday Times on February 12, 2017, with the headline 'What is 'contra trading'?'. Print Edition | Subscribe