Let’s have a look at Burberry Group PLC – the quote is currently at 1319 – 1322 and you think that due to strong fundamentals the share will grow. So you decide to buy 5000 CFD- shares at 1322p, the total value is £66,100 (number of shares x price). You do not pay any commission, since everything is already incorporated into the spread.
As the share is margined at 10% you only need to deposit £6,610 to open the trade. This margin rate does not necessary mean that you have to use it. Because of the variable margins you can decide if you want to increase it, if it suits you trading style more.
Now you have an open long position and you wait for the price to rise, so you can sell at a higher value to realise profits.
Let’s say that your predictions were right and you watch the price rising. It is at the level where we quote 1454-1457 and you decide to take your profits, so you sell at 1454 the whole lot of 5000 shares. The proceeds from the transaction are 1454p per share – taking into account the cost of acquiring 1322, your profit per share is 132p. As you traded 5000 shares your total profit would amount to £6,600.
With your initial outlay in form of margin deposit of £6,610 you have made a profit of £6,600, which translates into a return of 99.85%. This is significantly more than trading the shares the traditional way, i.e. paying the full value of £66,100 to open the position. In that case the profit you have made would represent 9.98% return on your initial investment. This is the mechanism of leverage – it magnifies your profits. (But it also means it can magnify significantly your losses too).
Let’s assume for a while that Burberry has not gone up as you anticipated on that day, but you are still convinced the share will recover and decide to wait. Hence you leave it open over-night. For that reason your position will be adjusted by the funding charges. The charges represent the financing costs has incurred to create the investment. They compensate for the part of capital needed to open the position that was not covered by your initial deposit, in this case 90% of the total value, as your effective margin rate equals 10%.
Burberry closed at 1297 and this is the price used for the purpose of funding calculation. The total value of your position is thus £64,850, with £58,365 lent by us.
With the current LIBOR at 0.5% and we funding spread of 2%, the applicable funding rate would be:
0.5% +2% = 2.5% per year.
As you only hold your position for one day it equals 0.00685%. Based on that calculation a total of £4.00 will be debited from your account.
You should consider funding charged when calculating the overall performance of your trade.
During that period the company goes ex-dividend - Burberry decided to distribute its earnings and pay out 10p share. As a holder of a long CFD position you are entitled to participate in the earnings sharing and receive 100% of the declared dividend of a UK company.
For non UK companies, the dividend may be subject to withholding tax. If you had a position in US stock, the announced dividend is subject to 30% withholding tax. Being a UK resident firm, we claim a 15% tax benefit, which we pass on to you and therefore, you will be credited 85% of the announced dividends rather than 70%.
Unfortunately, unlike you anticipated, the Burberry shares did not turn around the following day and continued on their way down. They fell down to 1231-1234 and this is the moment when you decided to cut your losses and sell at 1231. By doing that you realise a loss of 91p per share or £4,550 in total [=5000 shares x (1231-1322)].
The two above scenarios exemplify the mechanics of leverage. Trading on margin, i.e. with borrowed capital allows you to multiply profits by committing only a fraction of the trade’s total value. You still, however, participate in the full movement of the price. In this case, committing £6,610 generates a profit of £6,600 – a yield of almost 100%. If you were to pay everything upfront, you still would have made £6,600, but the yield was just around 10%.
The same magnifying mechanism applies to losses as well though. In the second scenario your losses amounted to almost two third of your initial capital. In adverse market conditions they may as well exceed your initial outlay. That is why it is imperative you do understand all the risks associated with trading on margin.
You can control the amount of leverage of your trade by using variable margins we offer you. So it is up to you how much or how little debt you want to apply before committing to a trade. The higher the leverage the higher is the multiplier of potential profits, but also potential losses on your position. The smaller the leverage you use, the less you have to pay for funding of overnight positions.