CFD's Versus Spread Bets

These are now the preferred vehicles for active traders, although they have somewhat different characteristics. Both products allow the user to go short and also, being margined products, the user can gear themselves up, in other words, take an underlying position that is a multiple of his funds. For example, if the margin rate for Barclays were 10%, establishing a £100,000 position would only require a deposit of £10,000. Any running profits can be used as margin to establish new positions, however running losses must be made good by either reducing the position or providing additional funds. This gearing effect clearly demonstrates the importance of trading discipline and capital preservation. Too many times traders find themselves in a corner by over committing themselves too early and missing out on other opportunities that they would otherwise have been able to take advantage of.

CFDs do not have an expiry date and being a margined product, a daily funding charge will be applied to the account for long positions held overnight. No interest is accrued or debited on positions opened and closed in the same day. Short positions attract an interest rebate. No funding charge is applied for positions opened and closed in the same day.

Spread betting positions are very similar to futures products. They have an expiration date - the position will only remain open until the contract runs out, at which point it will be automatically closed or rolled over by the trader. This is a marked difference to CFDs, which do not. Spread-bets also have a premium already built into the price and will generally trade above the underlying share price, somewhat similar to a futures contract, which has an associated 'fair' value based on funding charge until expiry and any dividends payable.

Corporate actions are generally applicable to both with the exception of dividends. With spread-bets, the anticipated dividend, if any, is built into the initial price, whereas with the CFD, the holder will receive a credit of the net dividend, or pay away the gross dividend if short over the ex-dividend date.

CFDs are liable to capital gains tax at the investor's marginal tax rate after the annual allowance has been surpassed, while gains from spread bets are tax-free. This can cut both ways however, as although no one ever places a trade intending to make a loss, losses at some point are an inevitability. Losses incurred through spread-bets are gone for good, while CFD losses can be offset against future profits for tax purposes.

The most important factor of all is the bid-offer spread. A spread-betting firm posts its own two-way price like a bookmaker, a take it or leave it price. Most CFD providers however, allow you to post orders within the bid-offer spread enabling the individual to become a price maker rather than a price taker. Also, on large orders CFD Providers may be able to improve on the bid-offer spread available in the market place. The bid-offer spread is the most significant cost of trading and is the main reason why hedge funds use CFDs and not spread- bets. Access to the main market also means access to real prices and the pool of deepest liquidity. At some point the trader will need to exit the trade and may find himself disadvantaged by dealing with a counterparty that not only knows his position but can quote a price that may more suit the provider than the individual.

Another obvious difference is the way trades are placed. A spreadbetter is betting a certain amount of money per point on any given market. CFD traders will trade a certain number of shares, just as in conventional share trading.

Spread-bets on the other hand have a premium already built into the price and will generally trade above the underlying share price, somewhat similar to a futures contract, which has an associated 'fair' value based on funding charge until expiry and any dividends payable. Corporate actions are generally applicable to both with the exception of dividends. With spread-bets, the anticipated dividend, if any, is built into the initial price, whereas with the CFD, the holder will receive a credit of the net dividend, or pay away the gross dividend if short over the ex-dividend date.

CFDs are liable to capital gains tax at the investor's marginal tax rate after the annual allowance has been surpassed, while gains from spread bets are tax-free so that appears to give the latter a distinct advantage. That works both ways of course in that, losses incurred through spread betting are gone for good, whereas losses on CFDs can be used to offset capital gains elsewhere, and can be rolled forward. There is also an annual capital gains tax allowance. No one places a trade intending to lose money, but the reality is that some trades will be loss making and the tax situation deserves some consideration.

Also, if you open a CFD position in a foreign index - the MIB 30, for example - your investment will be in euros per point. By contrast, a spread-bet is almost always structured in terms of pounds per point, even if the underlying stock or index is American, Japanese or Italian. The effect of this is to expose you to two investment variables. As well as the index, you may make or lose money from the currency exposure between the time you open and close your position. A 2 per cent rise in the Nasdaq will do you no good at all if the dollar falls 2 per cent over the same period. This consideration doesn't apply with spread-bets. Given that foreign exchange markets are generally more volatile than stock markets, and that your exposure to small movements will be higher with a geared spread-bet or CFD, the extra currency exposure may tilt you towards a spread-bet.

The second quirk of an index CFD compared with a spread-bet is that you receive the underlying dividend. With the Footsie currently yielding around 3 per cent a year, that will make little difference if you are opening an index position and expect to hold it for a few days - that 3 per cent a year equates to 0.06 per cent a week. Dividends are credited or debited to your account as they are paid out by the underlying companies, depending on whether you are long or short of the index.

The real issue is the relationship between client and provider, which is intrinsically different between CFD provider and spread better. A spread betting firm is no more than a bookmaker and the client is no more than a price taker of the two-way price that he is offered. He has no way of influencing that price or dealing at a more favourable price than that offered. The firm, may or may not hedge out the transaction and has every incentive to sell at the highest price it thinks it can achieve and buy at the lowest, there is little incentive for improvement. Client and spread betting firm are true counterparties.

With the CFD provider however, the relationship is entirely different and more along the lines of a traditional stockbroker, who acts as agent. Although counterparties to the CFD transaction, as the broker is hedging in the cash market, any price improvement is passed onto the client as no spread is added on. Most CFD providers allow you to post orders within the bid-offer spread giving access to the greater liquidity of the main market and more importantly enabling the individual to become a price maker rather than a price taker. The broker earns commission on the trade and charges a funding charge on the borrowed funds. The CFD provider may also provide supporting reports and research, be a source of commentary and opinion and be able to relay market gossip and stories, often invaluable information. Hedge funds don't use spread bets, they utilize the established CFD marketplace for short-term trading and as many traders regard themselves as running what is effectively their own mini-hedge funds, it would be as well to give this fact due consideration. Small improvements on execution price have a dramatic cumulative effect on annualized returns, which hedge funds are particularly sensitive to and in addition they value the access to local liquidity, transparency and flexibility to make their own prices.

In summary, spread betting is an excellent entry-level product on which the less experienced trader can hone his skills. It is extremely scaleable, in that as the only cost is the bid-offer spread, it makes it as cost effective to do very small trades as larger ones. With a CFD trading platform, there can be more fixed costs, but as some point the more experienced active trader will want to move on to CFDs due to their inherent advantages. Issues such as stock liquidity, market capitalisation and anticipated time scale are all considerations when placing any trade and can determine what if any is the most appropriate instrument.

CFDs Vs Spread Betting - Similarities at a glance

CFDs Vs Spread Betting - Differences in a nutshell

1. When dealing in Shares you deal in the number of Shares not £'s per point. (1000 Shares not £10 per point).
2. CFD's are an ongoing Contract that will only expire when you actually close it.
3. CFD's are usually priced based on the Cash price of the market (Financial Spreadbets can be Futures based e.g. Quarterly).
4. CFD's attract financing charges. A Long position carried over to the following day will attract an Interest charge debited to your account; a Short Position will attract Interest credited to your account. Interest is calculated on the total value of your position.
   The Interest rate will vary from provider to provider but as a rough guide it will be the official overnight Cash interest rate plus say 1.5% for Long positions and less 2.5% for Short Positions. So if the overnight rate is 4% you will be charged 5.5% on Long positions and receive 1.5% on your Short positions. Interest is calculated and applied on a daily basis.
   (Please Note: Some Financial Spreadbetting companies offer a Rolling Cash Bet which operates a similar system, however the majority automatically close out Daily positions. Longer-term bets e.g. Quarterly, have the spread adjusted to reflect interest charges. Interest charges are often referred to as Cost of Carriage.
5. CFD's allow the owner of a Share CFD to partake in Corporate Actions e.g. Share splits, Dividends.
   The owner of a Long share or Index CFD will receive dividends in much the same way as an actual shareholder but Short CFD Share and Index positions will have the dividend deducted from their accounts. (Each provider treats Dividend slightly differently so please do check.)
6. CFD's are subject to Capital Gains Tax.
7. Commission Charges may be applied to some or all transactions.

 Also see examples of CFD trades when compared to a Financial Spreadbetting

 Comparing the Costs of Spread Betting and CFDs

 Which instrument for which Job?

 Argument for CFDs