Trading on margin

In 2000 City Index introduced an alternative to traditional stock trading called contracts for differences (CFDs). This new form of trading gives individual investors the chance to deal on the same basis as institutional clients. CFDs are ideal for short-term technical trading as well as for hedging positions in the underlying market. While giving all the benefits of the underlying equity market, they enable an investor to avoid many of the costs and problems involved in the purchasing of physical shares. A CFD is in essence a swap of cash flows. The purchaser receives all the benefits of the underlying shares, including price performance, dividends and so on, and in return pays a financing cost to the seller. It is akin to borrowing money and then using this money to purchase shares. The investor receives the benefit of owning the shares while paying interest to the lender. A CFD encapsulates both these transactions into a single transaction. CFDs are a margined product, allowing an investor to gain an increased return from the leverage this provides. With margin, a client is only required to deposit a fraction of the overall value of the trade, typically 10 per cent to 20 per cent. This enables the investor to take a much larger position than would have been possible were he to buy underlying shares. A maximum of Ł2000 would be needed to buy Ł10,000 worth of shares. A Ł500 profit on the transaction would equate to 5 per cent return if physical shares were not used for this trade; compare this to 25 per cent return if executed as a CFD. Losses are equally multiplied. The term CFD implies that you engage in a contract with a counterparty, the market, and you will settle the difference whenever you choose to. You will either receive payment or have to pay for your losses. Long A long position (speculating that the share goes up) in CFDs receives all the returns of an equivalent position if you bought through a traditional stockbroker. You will make a profit if the share price rises but a loss if the share price falls. In addition to this you will have to pay a daily financing charge (see example). Short A short position (speculating the share price goes down) in CFDs pays away any returns, should the share price rise, but will profit if the share price goes down. In addition to that you will receive a daily financing fee (see example). Example of a long CFD position in Vodafone Opening trade You decide to buy Vodafone. A City Index dealer quotes you 95.75 to 96 pence. You buy a CFD on 20,000 shares at 96. You pay no stamp duty. Price of Vodafone - 96 pence Number of shares - 20,000 shares Value of shares - Ł19,200 Stamp duty - Ł0.00 Commission - Ł38.40 (0.20%) Total value of transaction - Ł19,238.40 Initial margin requirement (10%) - Ł1922 Daily financing On a nightly basis you pay financing for this position based on Sterling Libor (London interbank offer rate) and the daily closing value of Vodafone. Your financing rate might be Libor + 1.25 per cent. Assume that this equates to a financing rate of 5.25 per cent, and the daily closing price today is 98 pence. In this example you would pay (20,000 * 98 * 5.25%)/365 = Ł2.82 to hold the position overnight. This will be debited from your account on the next trading day. Closing the position Three days later Vodafone is trading higher and you call a City Index dealer. You are quoted Ł1.01 – 1.01.75. You decide to sell your Vodafone CFD position of 20,000 shares for the price of Ł1.01 or 101 pence. Price of Vodafone - 101 pence Number of shares - 20,000 shares Value of shares - Ł20,200 Stamp duty - Ł0.00 Commission - Ł40.40 (0.20%) Total value of transaction - Ł20,159.60 Profit on trade - Ł921.20 Financing (3 days) - Ł8.46 (3 days * Ł2.82) Overall profit on trade - Ł912.74 This represents a return of 48 per cent (912.74 / 1922) on the initial outlay and demonstrates the powerful leverage potential for CFDs. This was an example of a long position in Vodafone. Let us use the same stock and the same data for the example of a short position. Example of short CFD position Opening trade You decide to sell Vodafone. A City Index trader quotes you 95.75 to 96 pence. You sell a CFD on 20,000 shares at 95.75. Price of Vodafone - 95.75 pence Number of shares - 20,000 shares Value of shares - Ł19,150 Stamp duty - Ł0.00 Commission - Ł38.30 (0.20%) Total value of transaction - Ł19,111.70 Initial margin requirement (10%) - Ł1,915 Daily financing When you short the market you receive money from financing. That is usually Libor – 2 per cent. This equates to 2 per cent. In this example you would receive Ł1.07 based on the following calculation: (20,000 shares * 98 pence closing price * 2%)/365 = Ł1.07 This will be credited to your account on the next trading day. Closing the position Three days later Vodafone is trading higher and you call a City Index dealer. She quotes you Ł1.01 – 1.01.75. You decide to buy back your Vodafone CFD position of 20,000 shares for the price of 101.75 pence. Price of Vodafone - 101.75 pence Number of shares - 20,000 shares Value of shares - Ł20,350 Stamp duty - Ł0.00 Commission - Ł40.70 (0.20%) Total value of transaction - Ł20,390.70 Loss on trade - Ł1279 Financing (3 days) - Ł3.21 (3 days * Ł1.07) Overall loss on trade - Ł1275.79

CFDs stand out from traditional share trading in a number of ways

• You do not have to pay the full price for the share. You only pay a small percentage of the overall value of the investment. This is called trading on margin. The margin payment is usually 10 per cent of the overall value of your investment.
• You can take advantage of falling share prices – called “shorting” the market. This is a big advantage in a bear market where the general trend of prices is down. If you hold a short CFD position you will pay away the dividend.
• There is no stamp duty to pay, as you will never physically own the shares. You will still receive dividend payments if you are speculating that the share will increase in value, i.e. the price will go up.
• You can trade CFDs using both the phone and the Internet.