Spread Betting versus CFDs

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Spread Betting versus CFDs

Q.: What is the difference between spread betting and contracts for difference?

A: Spread betting is regulated slightly differently so in practice any 'Joe Blog' can open an account. Contracts for difference generally require a user to have a level of previous experience.

The difference between CFDs and spreads is also not how they are hedged. Neither are required to be hedged. CFDs are opaque derivatives, and the provider is not required to hedge, except to protect themselves. The key difference between CFDs and spreadbetting are the tax implications and the transparency:

CFDs are taxed as financial products, so qualify for capital gains tax. Spread betting is classed as gambling where gains are free of tax. (However, spread betting debts are not classed as gambling debts, and are fully enforceable).

Most spread betting and CFD brokers take their prices direct from the underlying stock exchange. With an equity rolling daily spreadbet they will then typically add a fixed markup to the bid-offer spread. If you deal with a CFD market maker the pricing will be similar to spread betting whereas if you deal with a DMA broker there will be a separate charge for commission, which is usually as low 0.1% on each leg of the transaction.

Another notable difference is that contracts for differences are priced in the denominatory currency of the issuing country as opposed to a spread bet which are usually priced in sterling or euros (depending on the base of your account). If located in the UK this makes the CFD of an international asset more attractive should sterling depreciate in value.

CFDs are designed to be traded just like shares. The supplier of the CFD will quote market prices (sometimes an additional spread), and charge a fixed commission, just like you were buying real shares. High end providers, will give you access to the underlying stock market order books, and will trade your CFD at that exact price - potentially this is a totally open system. If the share pays a dividend (the dividends is paid out as cash to 'longs'; shorts have to pony up the dividend cash). CFDs also have the life of a share - you can usually keep a CFD open, as long as your account is funded, as long as the shares are traded.

Dated spread bet quarterly contracts are based upon the futures market price of a share (or your bookie's quoted price) rather than the price of shares in the open market. Dividends aren't paid/charged, instead the futures price usually incorporates a correction for the expected dividend (which provides a similar type of effect). Spreadbets also have a finite length - e.g. You'd make a FTSE100 July bet (the price quoted when you make the bet, will include expected dividends - and the bet will terminate on the 31 July). Spread bets are traded as a 'stake per point'. E.g. You'd place a Tesco shares July bet at £1 per point - this would pay out £1 for every fraction of a penny that the share price changes. If the shares cost £4 each - a £1/point bet would be equivalent to buying (or shorting) £4000 of shares. Typically there is no comission to pay for spread betting. The bookie's cut comes from the spread.

Q.: What are best: spread bets or contracts for difference?

A: Both products are in reality very similar. The investor does not own the real asset and benefits from a change in its value. Spreadbets have the 'no capital gains' tax advantage in the UK but you cannot offset any losses against other tax you may owe either. For most traders, this won't be a problem, but if you have a sizable tax bill or fairly complex tax planning, the ability to deduct any losses may come in useful. For instance, if you're trying to use trades to hedge a long-term investment portfolio, it may be important to have the tax liability on both your portfolio and your hedge match up. For example, you can hedge your shares portfolio when on vacation or in the closed period around a firm's market announcements to ensure that gains and losses will be null; i.e. use the side that incurs a loss to offest your capital gains tax bill. In fact, in practice all contracts for difference losses incurred can be used against the sale of other tangibles such as the purchase of a second house.

With CFDs you can set your price and take advantage of the spread or trade within the spread, you also get to move the price yourself and participate in auctions. For the most part the odds are better trading with Direct Market Access CFDs (not always though) than spread betting. Even with DMA, you don't always get filled, at the price requested, depending on what kind of order you are sending to the market.

You can make money at both spread betting or Direct Market Access although in theory the odds are against you in spread betting for 2 main reasons: you pay the spread and secondly you are at the mercy of the bookie (dealer intervention, orders delay...etc ). In DMA the odds are not always against you, it really depends on your trading style, if you are a scalper then joining the bid and offer may cut costs in the long run (in fact you can earn some spread). This is obviously theory and not all traders can be successful scalpers.

To summarise if you can cope with a higher deposit, stakes, margin and so on, Direct Market Access is definitely to be preferred (unless you feel the taxation issue for spread betting overrides this). However, spread betting still plays an important part for many traders and not only newbies... - CFDs vs Spread Betting are discussed in more detail here.

Q.: Why is direct market access seen as more transparent than spread betting?

A: When you place a spreadbet you are betting against a bookmaker. You are not really contributing in to the markets, you are making or losing your money against your spread betting provider. So if you place a bet and you get it right, the bookie is paying you. You get it wrong, you are paying the bookie.

With direct market access (DMA trading) you are a participant in the market. So for instance if you are trading with one futures contract, you are buying or selling from another person present in the market. These transactions are facilitated via a direct market access broker. Unlike spread betting where the commission is part of the spread; with CFDs you pay your broker a commission to buy or sell the contract on your behalf. In such a scenario, the broker couldn't care less whether you make money or not since he gets his commission from your trading. So as you can see with CFDs you are the price maker (rather than a price taker) which is one of the reasons why hedge funds incline to use CFDs rather than spread betting.

So are you worse off with spread betting?

This is really a contentious subject but in a nutshell:

Spread betting is tax-free in the UK and Ireland. The government still classes the activity as gambling and as a result you are not liable to any income tax on your earnings. Also with spread betting, the barriers to entry are very low. If you have just £200, you can open an account and away you go. But, given that the spread betting company makes/loses money from you...well this is the bit that causes argument between traders...supposedly they play games to screw you over... some traders claim they will mess around with their pricing to deliberately stop you out or just plain close your account if you are doing too well.

Direct market access is a different story. To start with, the minimum deposit to open an account is much higher. Also, any income is taxable. But since you are participating in the markets, you are one of the market makers and you are merely paying your CFD broker a commission to execute your trades. If you lose, you cannot blame anyone. 'The market is'...

Q.: But assuming I'm a day trader, would you opt to go through the DMA route or spreadbets?

A: If you aren't successful day trading with spread betting then the same holds for CFDs i.e. you probably won't be successful day trading via Direct Market Access either...

I presume the only reason I still use spread betting is because I'm located in the UK where no tax liability is incurred on spread betting winnings. However, honestly, if larger stakes don't matter and you can accept the higher deposit and margin requirements, I would in most cases opt for the DMA route. Even considering that you have to pay taxes on any CFD gains, it is imperative to eliminate all uncertainties in your trading (especially when stakes are increased). And paying taxes is not such a bad deal considering that if after a year of trading you end up in the red, you can deduct the losses from your taxes not to mention that by paying tax you also add value to your social security and private status. On the other hand if you still feel that you are too inexperienced, stakes are too high and you are comfortable with your trading strategy then by all means go for the spread betting route. The small differences in spreads today between spread betting and Direct Market Access do not make it absolutely vital to trade DMA in order to be successful.

Whichever way you choose to go be aware of the risks involved (such as day trading during news releases which can be very tempting for forex traders but is also deadly) and apply a proper trade money management strategy to protect your capital. For me day trading often leaves me exhausted; mentally and physically so I prefer swing trading which gives you much more time to plan your trade.

Q.: But aren't CFDs liable to capital gains tax unlike spread bets?

A: Yes, unlike spread bets, profits on CFDs are liable to capital gains tax. That's because spread bet profits are treated as a betting win, while CFD profits count as investment gains. But gains are only taxable above the annual CGT allowance of £9,600. And CFD losses can be used to reduce taxable gains, which is not the case with spread bets. Generally for this reason I view spread betting as a more expensive way to trade a CFD and without the benefit of offsetting losses. Thirdly you can hold contracts for difference within a self-invested personal pension, where they will be protected from the tax man - but you can't do that with spread bets.

Q.: What are most cost-effective - spread betting, cfds or direct shares trading?

A: This depends on the time-frame - trades of less than three weeks cost moreorless the same whether using CFDs or daily rolling bets. Longer term trades are usually a little cheaper when using spread betting based on futures prices.

CFDs are more cost-effective than buying UK shares direct if held for the short-term as the 0.5% stamp duty exemption saving usually exceeds the CFD trading commissions. For longer term positions (1 month plus) the financing charges of CFDs tend to outweigh the stamp duty savings.

Q.: Spread bets and cfds are very similar yet most real traders say spread betting isn't investing, it's just a form of gambling - why is that?

A: I would highlight the following. While there is no 'explicit' commission charged on spread betting, it is still factored in and it is a hidden charge. Here is an example. City Index quotes you the following on bank of Ireland: 5 bid to 5.10 offered. The stock maybe trading at 5.04. So you buy at 5.10. Thus the stock must move at least 7c until you are in profit. That is the commission you are in fact paying. With a CFD, you can position your order closer to 5 to buy using direct market access (see example below). And so you are likely to hit profit a lot quicker.

As a trader, I prefer CFDs...true, spreadbetting is free of Capital Gains Tax in the UK (and this is the only reasons that CFDs have lagged behind spread betting there)...but the real advantage of using CFDs is by using direct market access (DMA) ...So say BKIR is 490 bid and 495 offered.. With DMA I can position my order within this spread. So I have the chance of getting a better price than 490 if I'm selling and better than 495 if I'm buying. Using spread betting, you are quoted a spread that you must buy or sell at... It's far better than dealing over-the-counter with a provider who only lets you trade on the bid offer spread.

Dealing DMA is essential, you can place your limit orders anywhere and because you are trading direct to the market your trades can be matched by anyone else dealing on the same exchange. Trade fills are also instant so there is no frustrating pause while you wait for a trade to be confirmed only to be re-quoted or have to re-submit the order again.

 ...Continues here - CFD Pricing: Daily Cash and Daily Futures