What are the Pros and Cons of Spread Betting Vs CFDs?
LONG ANSWER
A Contract for Difference (CFD) is a ‘derivative’ financial product. In other words, it is based on – or derived from – an underlying financial instrument such as a company share or equity index. This enables traders to speculate on the future value of the underlying company or index, without ever having to hold actual shares or futures contracts. A Spread Bet (SB) is not a derivative in the true sense of the word, as the prices quoted by a SB company are generated by them independently of the underlying asset. In theory, these could vary considerably from one SB company to the next. In practice, they tend not to, as computer algorithms would exploit the difference, a practice known as ‘arbitrage’ trading. With SBs, traders speculate on the per point movement - up or down - of the SB itself, as opposed to the change in value of the underlying asset. The precise mechanics of SBs and CFDs will not be covered here; however, there are links in the next post to sites that provide comprehensive explanations of how each of them works.
The FAQ will start by outlining what SBs and CFDs have in common, before highlighting their differences and respective pros and cons.
What do SBs & CFDs have in common?
• Tax
Under current UK legislation, all traders and investors pay 0.5% stamp duty on their equities transactions. However, no stamp duty is payable on either SB or CFD transactions.
• Gearing & Leverage
These are two words meaning the same thing; the former tends to be used in the UK and the latter in the US. They both refer to ‘margin’, which is a common feature of most derivative products. Margin is the percentage of the total value of a trade held on deposit with your broker. The relationship between gearing and margin is inverse, so that the smaller the amount of margin required, the greater the amount of gearing or leverage. Margin rates vary from one broker to the next and from one instrument to the next. But, typically, it’s around 10% for equities. So, if you wanted to buy £10,000 worth of shares with a conventional broker, you might have to stump up the full £10,000. With a SB or CFD broker, you would only need to deposit £1,000 in your account. The benefit of this is that you can take larger positions and/or more positions than you would otherwise be able to do if you were to trade actual shares. The downside is that your exposure to risk increases significantly and, potentially, you could lose more than your initial investment. It’s primarily for this reason that derivative products such as CFDs are perceived as being very risky.
• Long or Short
Historically, most traditional brokerage firms only offer their clients the opportunity to buy shares in the expectation of a rise in their value. It’s relatively unusual for their clients to be able to sell shares they don’t own; a practice known as ‘short selling’, (This is more so in the UK, less so in the U.S.) Both SBs and CFDs enable clients to trade freely in either direction, so they can trade the market short and profit from a fall in price, just as easily as they can trade it long and profit from a rise in price.
• Financing Charges
Both products incur a financing charge if positions are held overnight. This is especially important to SB traders as they tend not to day trade, i.e. they tend to hold positions for a few days or more. Interest is paid to the SB company for long positions and (usually) paid into their client’s account by the SB company for short positions. Please see the links below for an example of how these charges are calculated and applied. Additionally, because both products are traded on margin (see ‘Gearing & Leverage’, above), traders will pay interest on the balance of their position. So, in the earlier example, someone who trades £10,000 worth of shares with £1,000 of margin will be charged interest on the balance of £9,000 which, in effect, they are borrowing from their broker.
• Controlling Risk
Many brokers (but not all) who provide SB and CFD accounts offer their clients a facility known as a controlled risk bet (CRB). For an additional cost, they guarantee to close trades at a predefined level so that you can be 100% certain of your risk exposure – even if some ‘black swan’ event occurs when the markets are closed. Holders of conventional shares don’t have this comfort and run the risk of overnight events impacting the price of their instrument, causing it to gap against them when the market opens for trading the next day.
• Minimal Restrictions & Many Markets
One of the benefits of both SB and CFD is the ability to trade a huge variety of markets from the same account. Very few ‘conventional’ brokers provide access to forex, equities, futures and commodities etc. all from one universal account. Additionally, some of the restrictions that can apply to day traders with ‘conventional’ share dealing accounts do not apply to SB and CFD traders. The obvious example here is the Securities & Exchange Commission (SEC) pattern day trade rule (PDT) which requires US equity day traders to have a minimum of $25,000 on deposit with their broker.
• Corporate Actions on Equity CFDs
SB traders don’t benefit from corporate actions such as share splits, rights issues or dividends in the same way that CFD traders do. For example, when the underlying asset goes ‘ex-dividend’, the CFD provider will credit traders with long positions (usually around 80% of the dividend) or, for short positions, debit their accounts (usually the full 100% of the dividend). SB firms simply adjust their prices to reflect dividend payments and other changes in the underlying asset. Neither SB nor CFD traders have any voting rights.
A little T2W tip is to be wary about entering short equity index positions such a FTSE 100 rolling bet on a Tuesday, as companies go ‘ex-dividend’ on Wednesdays. The quoted price will reflect the dividend payments, which could be unfavourable if you’re short the market – but, potentially, advantageous if you’re long. (Please note that this doesn’t apply to futures based bets as the dividend will already be factored into the quoted price.)
• Hedging
The term 'to hedge one's bets' is well known and is another use of SB and CFDs. Investors may own company shares and be committed to holding them for the medium to long term. However, during bear markets, the value of the shares could fall. To protect them from this possibility, they might elect to take a short SB or CFD position in an equity index such as the FTSE 100. If the value of the index goes down and the value of the individual share falls too (which is probable), the investor makes money on their short trade, thereby offsetting any loss in value of their share holding. This tactic provides peace of mind to investors and enables them to retain their shareholdings in the medium to long term. This mitigates the need to jump in and out of the market at every turn and, in so doing, incurring commissions, stamp duty and associated expenses.
How SBs & CFDs differ - plus their respective pros & cons
• Tax
The key difference is tax. Under current UK legislation, profits earned via SB are not subject to Capital Gains Tax (CGT), but profits earned via CFD trading are. Additionally, profits earned via SB are probably not subject to Income Tax. In theory, if you make a lot of money via SB and trading is your sole source of income, you might be liable to pay income tax. There is a lot of debate on sites like T2W regarding the official position on this issue but, to date, there are no known cases of HMRC demanding Income Tax from SB profits. The benefit of paying CGT (yes, there is one) is that if you lose money in one tax year, you can offset your losses against any profits you make the following year. You can’t do this with SB losses, which is the main reason why SB is tax free!
• Commissions
SB companies do not charge commissions on trades, whereas, most (but not all) CFD providers do. A SB has the commission built into the bid / ask spread which is nearly always wider than it would be if you traded the underlying instrument. This is the primary reason why SB tends not to be favoured by day traders who make many trades for relatively small gains. For them, the tightest spread possible is of paramount importance. Most CFD providers do not do this, i.e. they offer the tightest spreads possible and charge their fees and commissions separately. The size of the spread charged on any one instrument will vary from one SB firm to the next, as will the commission charged by the various CFD providers. As a general rule of thumb, if you’re trading in reasonable ‘size’, i.e. many tens of pounds per point, CFDs may prove to be a more cost effective option. Conversely, many CFD firms have a minimum charge, so if you’re trading small size, say just one or two pounds per point, then SB might be the cheaper route.
• Prices & Spreads
All SB prices are synthetic, meaning that the transaction is between you and your SB broker. In this respect, it’s the same as going to a bookie and betting on the outcome of the 3.30pm at Chepstow. If the horse you back wins, the bookie pays you. If it loses, the bookie keeps your stake, part of which is used to pay out other winning bets and the remainder is profit for them. The relationship between SB companies and their clients is a contentious one and the subject of numerous threads. In a nutshell, critics of SB firms maintain that they only profit when their clients lose. The SB firms deny this vigorously, arguing that – if true - this would be a flawed business model as they would forever be needing new clients to replace the ones who’ve lost all their money! They maintain that they hedge their order book and make most – or all – of their profits from the spreads.
The basic principles outlined above apply to some CFD companies as well – but not all. Some companies offer the option of ‘Direct Market Access’ trading (DMA). This will entail you paying a larger commission on your trades, but the spread will mirror the movement and size of the underlying instrument. Additionally, you will have potential to buy and sell between the spread, i.e. to buy at the bid and sell at the offer. With SB firms, generally, you will only be able to buy at the offer and sell at the bid. In other words, with a SB company, if you enter a trade and it goes nowhere and you decide to close it at break even, you will pay the cost of the spread.
• Expiry
Most markets and instruments offered by SB firms are based around the futures markets. Therefore, with the exception of daily rolling bets, they have an expiry date, usually daily, monthly or quarterly. Come expiry, open trades must be closed or rolled over to the next contract period - which usually incurs a charge. Trades that are left open will automatically be closed and the trader’s account debited or credited accordingly. With CFDs, there is no expiry date (except actual futures contracts), so you can hold positions for any time period you want. Keep in mind though that there are financing costs, so it probably won’t be advantageous to hold positions for too long. Having said that, at the time of writing (summer 2010), interest rates are at unprecedented low levels, so this isn’t as big an issue now is it is when interest rates are high.
• Currency & Trade Size
When using SB as your trading vehicle, you can trade in the currency of your choice. So, if you’re a UK based trader, you can trade any and all markets and instruments offered by the SB company in GBP£s. With CFDs, you must trade in the currency of origin for that instrument. For example, if you want to trade Tesco, you’ll do so in GBP£s, Google in USD$s and Nokia in Euros etc.
A SB trade size is determined by the number of £s / $s / Euros per point movement. Some SB firms allow you to trade in pennies per point increments while you’re learning, so you can get a taste for live trading without risking a lot. With CFDs, where one CFD usually equals one share, you’re trading the change in the value of the underlying asset from the time you open the trade to the time you close it.
• Last and Probably Least . . .
Many retail traders don’t perceive themselves as gamblers and don’t wish to be viewed as such. This isn’t an issue for professionals working for institutions or prop’ firms, but it can be for retail traders working from home. For the latter group, if they trade via a SB firm, there’s no getting away from the fact that the B stands for Betting. In the minds of many, betting is synonymous with gambling. Understandably, many people struggle to differentiate between trading and gambling, none more so than the spouses of retail traders! Consequently, some of them elect to neatly side-step this issue of spread betting by trading CFDs instead.
Summary
The scope of this FAQ has been to examine some of the pros and cons of SB and CFDs respectively. It is not meant to imply that either platform is inherently better than any other, or that either one is necessarily the best method for trading equities markets. On the face of it, both of them offer a number of advantages for equities traders in the short term, i.e. intra-day to a few months at most. However, rarely are SBs or CFDs suitable for holding long term positions. Furthermore, they are totally unsuitable for anyone with a gambling mentality who doesn’t understand the risks involved.
SBs and CFDs may or may not be the best option for short term traders who trade other markets besides equities. Other alternatives should be considered, such as: Futures, Options and Warrants. Please research all the available methods for trading the market(s) of your choice before deciding which one is best for you. The platform you end up with is likely to be governed by your trading style, the time frame you trade, your finances and personal circumstances. Good luck!
