In your opinion the earning numbers RBS is about to publish are going to disappoint the market. You are convinced that they will be below analysts’ consensus and will drive its price down so you decide to participate in the movement. The price is now at 27.38-27.46; you have assessed your risks and decided to sell at 27.38p with a £50 stake.
The position calls for an initial margin of £68.45 (5% of the total value £1,369). Now you have what is called a short position and can wait for the price to decline.
As you have anticipated, the company did not deliver – the earnings figures were well below everyone’s expectations. The price fell and is now at 23.21-23.25. You believe this to be the bottom of the move and decide to take your profits now. You buy back at 23.25; your proceeds from the trade were 27.38p, your expenses 23.25, the difference between those numbers would translate to 4.13p per share or £206.50 in total.
With an initial outlay of £68.45 in form of margin you have made £206.50 profit, which translates into a return of 301%. If you wanted to make a short sell directly in the market, the whole process would have been much more complicated as the shares would have needed to be borrowed from a party owning them for a fee. Spread betting enables you to take short positions and profit from falling prices without the hassle and without any additional cost that usually come when trading physical shares.
You should however bear in mind that short selling is a very risky strategy. While you can profit from falling prices, there is a limit as to how much the price will fall (the value of a share will never go below 0); at the same time the potential losses arising from such a trade have no such limit, as there is no upside cap on the price of a share.
As it turns out, the figures delivered were in line with expectations and did not move the price a large amount. Nevertheless you are still convinced that it will fall, so you leave it open overnight. This will attract funding charges – they can be either a credit or a debit depending on the market interest rate – the LIBOR.
RBS closed 28.36p; hence your position is valued £1418, with our commitment of 95% towards the position, i.e. £1347.10.
Assuming the LIBOR is currently at 0.5%, the applicable funding rate in this particular case would be:
0.5% - 2.5% = -2.0% per year.
A negative percentage means that you will be charged for holding a short position. As the position is held over one night, the daily charge will amount to 0.00548% and will be applied to the value of the position not covered by your margin. Hence £0.07 will be debited from your account.
You should consider funding charged when calculating the overall performance of your trade.
While your position remains open, the company goes ex-dividend and pays 3p per share. As you are short, the amount of announced dividend will be debited from your account. This transaction accounts for the fact that you actually sold the share (broadly speaking you are the counterparty of the long).
Taking into account the size of your position, a total of £150 would be debited from your account. This dividend payout should be considered in your overall profit and loss calculations. What you also need to bear in mind is the fact that the company’s share price often falls immediately after the profit distribution takes place.
Unlike you predicted, the share price did not fall and fluctuates around the same levels, so you decide to get out of the position. At that time we quote 27.96-28.01 and you decided to buy at 28.01. You have made a loss of 0.63p per share, so considering the size of your position that is £31.50 in total [£50 x (27.38-28.01)].
The two scenarios in this example illustrate the technical aspects 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, by employing £68.45 you generate a profit of £206.50 – a yield of around 300%. If you were to pay everything upfront, you still would have made £68.45, but the yield would have been just around 15%.
The same magnifying mechanism applies to losses as well though. In the second scenario your losses amounted to almost half 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.