CFDs and Spread Betting Compared

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.

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.

First, let’s take a look at their similarities…

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.

Trading Times and Contract Periods

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.

Where CFDs are Taxing

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!

Pricing Transparency and Trading Costs

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.

Index Trading

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.

CounterParty and Conflicts of Interest

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…

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.

CFDs Vs Spread Betting – Similarities at a glance

1. Both products are derivatives which means that you don’t own the underlying share, currency or commodity direct but rather a contract priced relative to it. The terminology is slightly different for CFDs and spread bets, but both offer the same degree of leverage and potential risk/reward for online trading.
2. With both spread betting and CFDs you trade on margin i.e. you need only put up a deposit of the total value of the position. Each Instrument has a Notional Trading Requirement and a Margin Requirement. In much the same way as financial spread betting this may be a % or a fixed £ value.
3. In both cases the contract will move up or down as the underlying market does, and you can go long or short to make money.
4. Because you do not physically own the Instrument there is no stamp duty to pay.
5. Some CFD providers offer no dealing charges. Some offer no commission charges on Indices but apply commission charges when dealing in Shares (Please do check with the providers.)
6. You Buy at the Offer Price and Sell at the Bid Price.
7. CFD’s allow the ability to Buy in the anticipation of a price rise and also Sell in the anticipation of a price fall.
8. The markets you can deal in are virtually the same. examples. UK, USA, Europe, Far East Australia etc.
9. When dealing with Indices, Sectors the trade is identical.
10. Much of the dealing terminology is the same.
11. You can place Controlled Risk Trades.

CFDs Vs Spread Betting – Differences in a nutshell

1. Spread betting prices are synthetic – based on the actual market price but set by the provider which means that the price you trade is not the price you see on Level 2 (typically, the spread will be wider than the market price as the provider adds a bit in for his commission). Spread betting firms post their own ‘take it or leave it’ price exactly as a bookie would, whereas with a CFD, you are the price maker. By contrast, a DMA CFD provider will allow you to post orders anywhere within the bid-offer spread. In general CFD prices are the best bid and offer prices from the actual offer and if you have direct market access you can actually trade on even better terms. What this means in practice is that trading contracts for difference can work out cheaper than spreadbetting and that costs are often more clear as the CFD spread quote will always be very close to the underlying price of the share or commodity that you are following.
2. One important difference between spread betting and CFDs relates to the counter-party. When you take out a DMA CFD either long or short it is technically a position against another trader (hence the name). Your CFD provider makes his money on his commissions and the interest charge he will levy every 24 hrs. If you lose money on your trade beyond these costs, your CFD provider doesn’t make any extra money. Instead when you take on a spread bet, you’re taking a bet against the spread betting company. They hedge your position internally or on the markets but they have an inherent interest in you losing on your bet. Not only do they make money on the spread and through commissions and perhaps financing over time, but they will make more money if you lose on your trade. This is something worth remembering. There’s a reason spread bets are classified as gambling and are tax free.
3. By definition spread betting providers are market makers meaning that they have the freedom to quote their own prices at their discretion (although they do say that they follow the market as closely as they can AND in fact the MiFID financial directive obliges them to do this). So in practice they CAN’T quote any price they want although there are cases where a spread betting company doesn’t follow the rules as applied by the industry. This means that occassionally you might find it hard to exit a trade or give too many re-quotes, freezing and such but by large things have improved dramatically over the past years and I believe this will continue as the competition increases.
4. When dealing in Shares you deal in the number of Shares not £’s per point (1000 Shares not £10 per point) although the exposure is the same. So for instance if opening a CFD position in say NEXT (NXT: LON) this would be quoted in the same way as if a normal share purchase was being made. i.e. ‘buy 1000 Next CFDs’ – with spread betting you are technically betting on the price movement of the share so the equivalent trade would be ‘buy Next at £10 a point’, where a point is a 1p movement in the share price. Note that the exposure is still essentially the same. In both cases, you simply ‘buy’ if you think that the price is set to rise, or vice versa.
5. With CFDs, positions are denominated in the currency of the underlying asset so if you’re betting on Gold, your profits or losses will be in dollars, and if you’re speculating on a Swedish Share, it’ll be in Swedish Kroner. Even commodity prices may be set in alternative currencies – gold is denominated in dollars. If you were to place a spread bet on Gold or an overseas security your profits and losses would still be in sterling which makes spread betting more convenient for retail investors. In practice, however, most CFD trades take relatively short-term positions of two to three days and, as a result, are unlikely to see significant currency swings, although there is a risk of this.
6. Unlike a spread betting firm which makes its money from charging a wider bid-offer spread than is available on the markets, a CFD firm charges a percentage commission on each trade (ranging from 0.1 per cent to 0.5 per cent on each trade).
7. CFDs 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.
8. The costs of financing a CFD position, as well as commission, are not wrapped into the spread, but are charged separately. Because of this, the CFD spread quote will always be very close to the underlying price of the share or commodity you are following. So you could say CFD prices are more transparent than those for spread betting. It’s easier to see where the CFD price is coming from.
9. CFDs are more flexible than spread bets, which often have set expiry dates, whereas you can let your CFD to run and run.
10. 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.)
11. CFDs attract capital gains tax (CGT) if you make a profit. This is because in the UK (as in most other countries), traders must pay Capital Gains Tax on their profits from CFDs for which spread bets are exempt but CFDs have the advantage that losses can be offset against capital gains from other investments. Spreadbets cannot create losses for tax reasons (which reduce future gains and therefore CGT) whereas CFDs do. This makes CFDs more appropriate for hedging than spread bets since you can write off losses on CFD positions against gains elsewhere for tax purposes, just as you can with losses on the assets you’re hedging. But you cannot write off losses incurred via spread bets.
12. CFDs usually also allow for bigger positions and minimum contract sizes are also usually larger for CFDs, making them more appropriate to professional investors. CFDs are used more frequently to build up investment portfolios, so they are ideal for anticipating merger and takeover deals.
13. CFDs are also held for longer periods. This is even more so now that global central bank interest rates have fallen (as the cost of financing contracts for difference is correlated to Libor), this means that the cost of servicing longer CFDs has also fallen. Spreadbetters on the other hand often get in and out within a trading day.
14. You can open an advisory account with a CFD trading provider which allows your broker to give you recommendations on what to buy and sell. No such thing exists with spread betting – all providers are execution-only.