CFDs and spread betting (in the UK) are now the preferred vehicles for active traders - indeed, most of the main providers of spread betting services are also prominent in the CFD trading market (for instance one of the main market leaders; IG Group offers both a spread betting platform (IG Index) as well as contracts for difference (IG Markets) - indeed if you log in to the two spread betting and CFD platformss, you'd be forgiven for thinking they were the same thing.
From the ordinary Joe speculator view, both spread betting and CFDs offer the potential for untold riches for a small outlay, both dangerous to the unsuspecting but both as effective if used properly.
Both products present prices as 'bid' and 'offer' and allow the investor to go long or short allowing speculators to make money from rising or falling markets. In both spread betting and CFDs, you're not physically acquiring the instrument - no shares are actually changing hands (which is why neither attract stamp duty in the UK). Instead, you're either speculating on how the price will move as in spread bets or entering into a contract that you buy at one price and sell at another, paying out the difference (CFDs).
In addition both CFDs and spread bets are traded on margin which means that the investor can gear himself up, i.e. 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.
Both products are margin traded, so financing costs are applicable for both: with spread betting this is built into the spread and the rollover charge; for contracts for differences there is usually a daily funding charge which is 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. CFDs do not have an expiry date and 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 (usually daily, monthly, or quarterly), 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. It is important to note that the costs for a quarterly spread bet future are included within the spread. For contracts for difference the financing charges are applied separately, resulting in a tighter spread - this may suite some traders, but not others.
Corporate actions are generally applicable to both with the exception of dividends. With spreadbet future 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.
Both spread betting and contracts for difference don't incur stamp duty. However, CFDs are liable to capital gains tax at the investor's marginal tax rate after the annual allowance has been surpassed (currently at £10,100 in the UK), while gains from spread bets are gloriously 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 inevitable. Losses incurred through spread-bets are gone for good, while CFD losses can be offset against future profits for tax purposes. This also works from a psychological perspective. If you're winning, you are okay with paying CGT since you are up anyway. But if you are losing money and know that you are likely to be paying a wider spread (with spread betting), that's quite annoying as you are already losing money!
Given that CFDs are subject to capital gains tax why would anyone want to use them over spreadbets that are tax free? The answer is in the prices, especially if you're using it in conjunction with direct market access. The trading cost with spreadbets and CFDs is often represented by 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. Moreover, 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 spreadbets. Access to the main market (live market prices) also means access to real prices and the pool of deepest liquidity. This means that you have more protection should the market move aggressively against your position, but with spread betting you trade slightly behind the market, against an often wider spread, and the contract is between yourself and the market maker. 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.
The cost of trading CFDs decreases as the value of the contracts rises. In most cases they provide tighter spreads and more flexibility over prices.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 or lots, 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.
Margin requirements are also the same on shares but may differ on other markets like index trading. This is because, with the spread bets the margin is calculated by multiplying the stake by the notional trading requirement, whereas with the CFD it is worked out as a percentage of the exposure.
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.
This is where we get to the fundamental difference between CFDs and spread betting - as 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 makes its own prices, based on the actual market price. It 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. While a spread betting provider is obliged to offer clients best execution, the conflict of interest is still there...
With the DMA 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. With a CFD, it is possible to use DMA (direct market access) 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 terms of use, contracts for difference have the edge for stock market trading, accounting for 40% of London Stock Exchange volumes, and many investment banks tend to use CFDs simply because they tend to track the underlying price more than spread bets.
To conclude, CFDs can offer advantages over the longer term but spread betting are still an excellent trading 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 at some point the more experienced active day trader might 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. However, I keep hearing CFDs described as the 'professional' traders' tool, compared to spread betting, which is disparagingly described as 'for beginners'. I don't hold with this as I don't want to pay tax if I don't want which makes financial spread betting a good trading tool especially for UK and Irish residents.
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