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Let's use a typical example. Your first choice would be to buy the Physical Shares of Vodafone. If you bought the Physical Shares you would pay Stamp Duty of 0.
Let's assume you also pay 0. You will also pay 0. You have bought the physical stock, therefore you will receive dividends which you can take or re-invest and you will receive a vote at the Annual General Meeting of the company. You will even receive a nice share certificate stating that you are a Vodafone shareholder.
You can hang this certificate on your wall and feel very proud. On any profits from this transaction you will pay U. The price of this contract is derived therefore from the underlying asset i.
This is why the contract is a called a "Derivative. You may not have even closed your position at this point. This is called "A Mark to Market Profit and Loss" - The broker will take the closing price of Vodafone each day and pay the "Difference" into your account if you are making money, and you pay the broker if you are losing money on the position. The reason the contract is called a "Contract for Difference" is for this very reason.
Typically, when you enter a position, the broker will "Hedge" their position by trading the underlying position in the market. The broker will then go into the underlying physical market and buy Vodafone physical stock in order to "Hedge" their position to the contract.
Regardless of whether Vodafone goes up or down, the broker is now in a position in which they will not lose. If the broker chooses not to Hedge, then they are implicitly "Short" the underlying stock, in this case Vodafone. If the stock does go up, the broker will be losing the equal and opposite amount to which you are making and vice versa if the underlying stock goes down. In the vast majority of cases, brokers do not like this risk and they simply hedge it out.
For commission rates, you will pay an Execution Only rate or Advisory Rate. Typically an Execution Only rate is 0. You will pay this if you are not receiving advice from a broker. Typically an Advisory rate will vary from 0. You will only pay this rate if you are receiving advice from your broker on what they think, you should be buying and selling i. You may or not be subject to Capital Gains Tax on profits from trading on CFD depending on your individual circumstances.
If you are subject to U. In the Vodafone example, when trading on CFD, you will also receive any dividends paid by the underlying asset i.
The broker will adjust the price of the contract in your live trading account , by the equivalent amount of the dividend on the day the dividend is paid known as the "Ex Dividend Date. This adjustment will be made in your favour so it is the same as receiving the full dividend. One of the main advantages of trading on CFD is having the ability to "Short" the contract or take advantage of the underlying price of the asset falling.
Instead of buying the contract from the broker, the broker buys the contract from you. So you are selling "Short" the underlying asset to the broker who will be implicitly Long. If the price of the asset then falls you will make money and the "Difference" will be paid into your trading account on a "Marked to Market" basis based on the closing price of the underlying asset each day.
If the underlying asset goes up, you will lose money and the broker takes the "Difference" out of your trading account each day. Trading short can be more dangerous than trading long.
If you trade short, theoretically you can lose an infinite amount of money. The asset could go to infinity! Be careful when shorting on CFD or when utilizing any "vehicle" that allows you to short. You can expect to learn a whole lot more than this on our Educational Trading Programme. To be redirected to this area of the website click HERE. In terms of dividends, when you are short a CFD contract, you will also be what is termed "Short the Dividend" - When the company pays its dividend on the ex Dividend Date, The price of the contract will be changed in your live trading account , to reflect the amount of the Dividend in favour of the Broker.
You will be paying out the amount of the Dividend. Your initial deposit is known as your "Initial Margin. Let's go back to our Vodafone example. Well, the broker in this example will typically allow you to borrow up to ten times the amount you deposit on account to trade in Large Cap stocks. This is what we mean when we say that your initial deposit is used as collateral in your trading account to enable you to trade on Margin with. The amount you pay to cover your losses on a daily basis is called your "Variable Margin.
It is because the Broker will literally send you an email and pick up the telephone and Call you to deposit more money into your trading account to cover the loss. If you cant stump up the cash, then the broker will trade out of the position on your behalf and crystallise the loss. In this instance you would be wiped out. You would be right. But you are missing the point here.
What usually occurs when Retail Traders are trading on Margin is that they will utilise all of the leverage they are offered by brokers. This can be across one position or many positions. That's not so unrealistic. Retail Traders make this mistake all the time. They think that just because the broker offers them ten times what they have deposited on Margin, they have to utilise it all. This is not the case. Professional Traders do not expose themselves to these types of situations.
Retail Traders typically do not understand why they are taking a position in something, what their real exposure is, what a sensible position size is in terms of utilising leverage efficiently and when they have a position, and also how to manage their risk effectively when things go right for them and wrong for them. Remember, trading on Margin can result in significant gains AND losses and you can lose all of your initial deposit AND more if you do not know what you are doing.
This is why it is essential to understand how to trade properly instead of being taught by someone who has never traded before, doesn't trade themselves and has a conflict of interest to your long term profitability. If you would like to know more about this then please go to the section on this website entitled "Trading and Portfolio Management Education.
CFDs are a leveraged product and can result in losses that exceed your initial deposit. Trading CFDs may not be suitable for everyone, so please ensure that you fully understand the risks involved. Find out more Contact. Institute of Trading and Portfolio Management.