Let’s have a look at Vodafone PLC – the quote is currently at 166.28 /166.67 and you think that due to strong fundamentals the share will grow. So you decide to buy £5 per point at 166.67p, the total value is £833.35 (stake x price). You do not pay any commission, since everything is already incorporated into the spread.
As the share is margined at 5% you only need to deposit £41.66 to open the trade. 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 178.52-178.91 and you decide to take your profits, so you sell at 178.52 the whole £5 position. The difference between your entry price and your sell price is 11.85 points. As you traded £5 per point your total profit would amount to £59.25.
With your initial outlay in form of margin deposit of £41.66 you have made a profit of £59.25, which translates into a return of 142.22%. This is significantly more than trading the shares the traditional way, i.e. paying the full value of £833.35 to open the position. In that case the profit you have made would represent 7.11% return on your initial investment. This is the mechanism of leverage – it magnifies your profits. (But it also means that you losses can be significantly larger too).
Let’s assume for a while that Vodafone 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. This will result in you being charged overnight funding. The charges represent the financing cost 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 95% of the total value, as your effective margin rate equals 5%.
Vodafone closed at 166.47 and this is the price used for the purpose of funding calculation. The total value of your position is thus £832.35, with £790.73 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 £0.05 will be debited from your account.
You should consider funding charged when calculating the overall performance of your trade.
During this period the company goes ex-dividend – Vodafone decided to distribute its earnings and pay out 10p per share. As a holder of a long position you are entitled to participate in the earnings sharing and receive 100% of the announced dividend, i.e. 10p per share. Thus a total of £50 will be credited to your account on ex-div day before the opening (5 x 10p x 1 = £50).
Dividend payouts constitute profit in overall profit and loss calculation. Please bear in mind that while a share goes ex-dividend its price often falls by that amount to account for the profit.
Unfortunately, unlike you anticipated, the Burberry shares did not turn around the following day and continued on their way down. They fell down to 157.38-157.75 and this is the moment when you decided to cut your losses and sell at 157.38. By doing that you realise a loss of 9.29p per share or £46.45 in total [=5 x (166.67-157.38)].
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 £41.66 generates a profit of £59.25 – a yield of over 100%. If you were to pay everything upfront, you still would have made £59.25, but the yield would be less than 10%.
The same magnifying mechanism applies to losses as well though. In the second scenario your losses amounted to over 100% of your initial outlay. In adverse market conditions they may dramatically exceed your initial outlay. That is why it is imperative you do understand all the risks associated with trading on margin.