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:
Gains on spread betting are not subject to CGT in the UK and Ireland, but neither are you able to ‘book the loss against any future capital gains tax’. You can of course do this with CFDs, which a distinct advantage of CFDs if a tax loss is incurred. 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). CFDs are usually quoted in the domestic currency of the market being traded – the Euro Stoxx in euros and the Nikkei in yen, for example. If located in the UK this makes the CFD of an international asset more attractive should sterling depreciate in value.
|Buy||10,000 shares||£100 a point||10,000 contracts|
|(Number Bought x Price)||(10,000 x 150p)||(100 x 150.10p)||(10,000 x 150.10p)|
|Cash Outlay (Exposure x Margin Req.)||£15,000||£1,501||£1,501|
|Sell||10,000 shares||£100 a point||10,000 contracts|
|New Total Value||£20,000||£19,990||£19,990|
|31 Day Financing||£0||£-30||£-30|
|Return on Cash Outlay||33%||330%||330%|
Total Exposure i.e. total value of shares is the same for all three trades. The main difference is the margin, amount you need to put up front. For Spread Bets and CFDs you generally only require in the region of 10% to be deposited to your account to get into the trade.
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.
We have reviewed the main differences between share spread bets and share CFDs but what about Forex spread betting and CFDs? Again, the main difference here is how you earn the money. With financial spread betting, you bet an amount per point, which is 0.0001. For instance, let’s assume that the exchange rate between the euro and the USA dollar is 1.4400 and you believe that the rate will increase (i.e. in other words that the euro will gain in strength against the dollar). You could, say, bet $100 per point that this will happen, thus as soon as the euro-dollar exchange rate reached 1.4401, you would have made $100. If the rate reaches 1.4405, you would have earned $500, but should the the rate fall to 1.4395, you would owe them $500.
In this respect Forex CFDs work slightly differently in that you could invest, say, $10,000 and hope that it strengthens against the euro. You would pay a margin deposit of this amount which would be, say, $100 (1%). If the forex rates were to move in the direction of your trade, you could sell your contract for difference, and the difference in value would amount to your profit.
Trading in CFDs is often compared with spread betting and it is important to make a distinction between the two. The main difference is that CFD spreads are market-determined, while betting spreads are set by bookmakers and therefore tend to be wider.
Tight spreads, price transparency and the fact that a CFD contract closely mirrors the underlying market all add to the product’s attraction.
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. Trading CFDs in practice means that you are speculating with contracts that have a pre-determined value; to increase your potential return (and loses), you trade more contracts. Spread betting is very similar – with spread betting a trader chooses how much each price movement is worth to him. For instance you might buy Vodafone at ‘£20 per point’; if it goes up in value by 10 points you win £200; if it goes down in value by 5 points, you’d lose £100.
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.
Sometimes, whether spread bets or CFDs are best will depend on the application. One important point to note is that while spread bets are usually denominated in the currency of your trading account (say sterling), CFDs are quoted in the currency of the market you are trading. This makes CFDs a better mechanism for hedging purposes. Say you are hedging $60,000 of market exposure to crude oil. You take out a short CFD trade on crude oil for $60,000. If crude oil falls, your short position will make profits in dollars to offset your dollar losses on your long position. If you had used a spreadbet to make this hedge you would have been left with a mismatch of sterling profits and dollar losses. This can leave you prone to exchange currency risks; for instance in this example it would be a problem if sterling falls against the dollar while you’re trading.
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.
Overall I would say that CFDs tend to be used for slightly shorter intraday trading or for perhaps two to three days. However, 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 around 10k in the UK. People people tend to forget that trading DMA allows you to do some accountancy tricks to reduce the profit so it is a balance between how much tax you think you are saving on spread betting (+ whether you can overcome the spread disadvantage) and what you would be taxed – you can work it out based upon your trade size, number of trades, win ratio, spread, etc. but there’s a few unknowns and changing variables in there.
And CFD losses can be used to reduce taxable gains, which is not the case with spread bets. Just as any gains via CFDs will be potentially subject to tax, you can also write off losses against gains elsewhere. My thinking is also that if I trade contracts for differences, when I lose money, I lose less money because the spread is tighter with CFDs than spread betting. Generally for this reason I view spread betting as a more expensive way to trade a CFD and without the benefit of offsetting losses. When you win you get charged Capital Gains Tax but this is only for amounts over your tax free allowance and you can hedge it against other loses. For the more serious traders and investors, this is a quite a worthwhile attraction.
Thirdly you can hold contracts for difference within wrappers like a self-invested personal pension that won’t accept spreadbets, where they will be protected from the tax man – but you can’t do that with spread bets. You can use these either to gear your returns or to act as a hedge to your existing exposure in some way.
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?
Spread betting and CFDs are both leveraged products with some differences but the principle is the same, speculating with more money than you have on movement of a share. While I know there are differences with CGT and commissions etc, the basic idea is the same.
And yet most ‘real’ traders say spread betting isn’t investing, it’s just a form of gambling, however CFDs are taken as a standard (albeit high risk) investment tool. Even the big guys invest millions in CFDs and yet wouldn’t touch a spread bet?
Why is this so when they are very similar investment tools? Why is it that many would say that spread betting is a mugs game but CFDs are ok.A: It is true that CFDs and spread betting have many features in common but legally speaking CFDs are classed as an investment rather than betting. This perception may add to the appeal of CFDs for investors.
As regards commissions 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.
Michael Hewson, an analyst from CMC Markets notes that the higher initial capital outlay required to trade contracts for differences prevents starters to trade the product and opt for financial spread betting instead, resulting in CFD traders being more sophisticated and experienced persons, that tend to have a longer-term trading perspective while being more patient to let their trades run. At the same time, financial spread betting has all its commission built into the spread while some CFD brokers charge a minimum commission in shares trading. Such minimum makes CFD more costly for smaller trades and cheaper for larger ones.
As for myself, as a trader, I use both spread betting and 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). Having tried both, I do somehow find that I am happier using contracts for differences as they seem to track the price of shares much closer than the spread bets – very similar in fact to that of a normal broker. 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 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.
‘We have 17 offices around the world, only one does spread betting, and the only reason we do this in the United Kingdom is the tax advantage.’ says Peter Cruddas, Owner of CMC Markets. He adds ‘the real growth opportunity for us is CFDs around the world.’
Q:So why choose CFDs over spread betting for a person located in the UK?A: Well, first and foremost for tax reasons! Sounds strange huh since spread betting profits are tax-free for UK residents while gains from contracts for difference are not… This may sound like a handicap for most traders (and actually it can be) but on the other hand spread betting losses are not deductable against tax, while CFD losses are. Thus, if you have a considerable tax bill or some complex tax planning, the capacity to deduct losses may prove useful.
As opposed to spread betting, contracts for differences are taxable and as a result are more commonly used as a hedging mechanism. Investors may utilise CFDs where they do not want to sell out of their share portfolios for tax reasons or because unwinding a large stock portfolio would involve expenses and administration. For instance, if you have a short trade running as a hedge to your long-term investment portfolio, it will make sense to have the tax status of your hedge lined up with your investment portfolio. An investor could also for instance short one of the main indices such as the FTSE 100 (if his stock holdings were principally in FTSE 100 blue chip stocks), so that they will make a profit on the CFD if the market falls, which in turn will offset any losses on their underlying portfolio.
In addition CFDs also cover dividends and bid-offer spreads can sometimes be more competitive than the spreads at some spread betting providers which is important for day traders.
Q:But I hate having to pay tax!A: Too much attention is paid to not paying tax. If you make a loss in a taxed account you can offset it against a gain. If you lose money in an ISA, it is lost. Depends how much tax you pay as to how that all works out and whether you make more money than you lose. Let’s say you make £20k profits and losses of £10k. Your tax return will show £10k…so no CGT to pay (starts at £10100). What’s best all depends on your circumstances; how much you expect to make…etc.
Q:So should I go with Spread Betting or CFDs?A: If you’re located in the UK or Ireland this is really a personal choice more than anything else. Most investors tend to go for one or the other. If they like CFDs, they don’t like spreadbetting, and vice versa.
Nothing wrong with spreadbetting it just depends on how you trade -:
- If you are a scalper, don’t use it use DMA.
- If you make less than 10k a year and trade stocks, use CFDs, you can trade inside the spread.
- If you want Level 2 stats, go DMA.
- If you are in the UK and trade and the spread is less than 10-20% of your expected profit, go spread betting for tax advantages…etc
Contracts for differences closely follow the market price while spreadbetting is completely free of costs and gains are exempt from tax in the UK and Ireland; except of course for the spread and any rollovers. So take your pick, or better still, mix and match! Personally, I do admit to viewing spread betting in bit of a negative light (although I do have spread betting accounts!) because I think they are mass-marketed towards a segment of the investing community which is inclined to think ‘rags-to-riches’ and not appreciate the risks involved…because the no tax advantage is stretched way too far…however having said that there is nothing intrinsically wrong with using the spread betting medium to trade.