Difference Between CFDs and Financial Spread Betting
I received a question recently from a friend of mine asking me what was the difference between financial spread betting and CFD (Contracts For Difference) trading. This is a good question and one I wondered about myself for quite a while when I first heard of CFDs. Over the last couple of years I went to a few sessions run by Davys and a few of the other firms who were trying to build up their CFD business. After going to these I realised that there is very little difference between trading CFDs and Financial Spread Betting. There are however a few subtle differences between the two which are worth being aware of, especially for those of you who are trying to make up your mind which route is best to go.
Spread betting is one of the older tools out there that has been used as an off the books method of purchasing and trading shares. They are mainly utilised by UK residents as a tax free alternative to trading the markets. CFDs are a newer and more sophisticated tool that are utilised by the rest of the world and are getting increasingly popular. So how do they compare? We will discuss CFDs vs Spread betting here.
Spread betting (which are mainly for UK residents) allows an investor to speculate on markets and make profits or losses based on their stake and how much the price moves. Both CFDs and spread betting offer traders potentially high returns. Spread betting is a type of CFD and investors can speculate on a wide range of assets and markets without taking physical ownership of the product being traded. Therefore, both products are derivatives. Also, both are leveraged products, i.e. you trade on margin and each instrument has a margin requirement, a fraction of the amount the underlying asset is worth. The margin requirement on both products is generally 10-20%, meaning that only 10% 20% of the assets value is needed to trade the value of the asset. Another similarity stems from the fact the underlying asset is not traded and that is there is no stamp duty in the UK to pay when trading either CFDs or spread betting.
As such CFDs and spread betting are both financial derivatives that trace the value of an underlying asset such as a share. They are both traded over the counter, with the main counter party in the transaction being the market marker. They are both quick tools to be able to trade against the movement of an asset and both offer a wide variety of markets to choose from. Plus as we have said already they are both traded on a margin, somewhere in the 5-20% range depending on your broker and the policies they enforce.
A Look At What They Have In Common
Ok, before I get onto the things that work differently between Financial Spread Betting and CFDs lets do a quick run through all the stuff that’s pretty much the same between the two:
- Both allow you the opportunity to go long or go short so you can take advantage of both rising and falling markets
- Both are free of stamp duty *
- Both are leveraged products which means a low initial outlay, you only need to put up a fraction of the total value of your trade, the IMR (Initial Margin Requirement) which can be as low as 2% on some markets, e.g Currencies.
- Following on from the previous point, because both are leveraged products, they are as a result both a high risk form of trading.
- With both all your trades are in the currency of your trading account, thus removing the risk of currency exposure, regardless of what market you trade.
- With both you never take ownership of the underlying instrument, so there are no share certificates issued and you have no voting rights at AGMs, etc
- With both you can trade a wide range of markets including equities, indices, currencies and commodities.
* Note: Tax Laws may change.
With both spreadbets and CFDs you qualify for dividends on long positions on equities, well sort of…Although you are technically not the owner of the shares, if you hold a long position on the ex-dividend date your account / position will be credited with a payment that is the equivalent of the net dividend on the underlying shares. There is a potential downside here however to be aware of, if you hold a short spread trade or CFD position on the ex-dividend date, then your account will be debited by the amount of the gross dividend on the underlying shares.
There is a Capital Gains Tax Liability on CFD Profits
So from the above I think it is pretty clear that Financial Spread Betting and CFD Trading are very similar, basically the same kind of financial product dressed up with two different names. However, as mentioned above there are a couple of material differences between that two. The big one for me is that with CFDs there is a Capital Gains Tax Liability on any profits made from trading CFDs. Some see this as a drawback to getting into CFD trading over Financial Spread Betting but the proponents of CFDs will argue that there is a benefit here too, in that any losses incurred while trading CFDs can be offset against profits made in order to reduce your tax bill. That ‘advantage’ sort of defeats the purpose since none of us get into trading to make a loss however losses are an inevitable part of trading so one has to take this in context.
The main differences between CFDs and spread betting are:
- Long CFD positions attract daily financing charges, while short CFD positions earn interest.
- No time related charges or benefits apply to spread betting.
- Capital Gains Tax applies to CFD trading in the UK, whereas no tax is applied to gains made via spread betting. This means that losses cannot be considered as tax-deductible when spread betting, whereas losses can be offset when trading CFDs.
- Consumers rarely pay commission in spread betting and the business’s charges tend to be included in the spread. With CFDs, the quoted prices usually match the underlying market and the business then charges commission for carrying out the trade.
CFDs tend to be linked to ‘real’ assets such as Oil, Gold and currencies, but spread betting takes place on markets across a wide range of activities, for example, the outcomes of sporting events and elections. Spread betting prices posted by firms are their own ‘take it or leave it’ prices, similar to how a bookmaker would price bets, whereas with CFDs, you are the price maker. This implies that trading contracts for difference can be cheaper than spread betting and the costs are often more clear. Also, the CFD spread quote is very similar to the quote on the underlying market.
When you take out a CFD, you are long or short against the position of another trader. The CFD broker does not make money if the trade incurs losses beyond the financing charges and commission. Whereas, if you take on a spread bet, you are essentially taking a bet against the spread-betting company. They will hedge your position internally or on the markets and have an inherent interest in their customer’s losing bets. They make money on the spread, the financing costs over time as well as when you lose your bet, making more money when you post a losing bet.
Another important difference is that with CFDs, positions are denominated in the currency on the underlying asset. For example, if you open a position in Silver, your profit and loss will be in terms of US Dollars. However, if you were to place a spread bet on Silver, your profit and loss would be denominated in Sterling, making spread betting more useful for retail investors.
CFDs are generally held over a longer timeframe, while spread bets are usually taken and executed within each trading day. CFDs allow for bigger positions and have larger minimum contract sizes. Contracts for difference are used in building investment portfolios, whereas spread bets are not.
CFD vs Spread Betting Example
Suppose you want to decide between a CFD or spread bet on the AUD-USD currency pair. If you take on a CFD, then your profit will be denominated in Australian Dollars, while for a spread bet from the UK, the profit will be in Sterling. Suppose you take a long position in AUD-USD. You buy 10,000 CFDs at 0.8800 and then sell the contract when the price increases. The value of this contract is £44,000 GBP but you are only required to put up £4,400. Suppose the price increases to 0.9300. The net profit will be (9,300-8,800) = 500 AUD minus any interest or other charges, assume this is equal to £2,500. Now if a spread betting firm offers odds of 42/41 and you think the rate will go higher than this, you would put a £44,000 stake on a rate higher than 0.8850. Then you would have made a profit of (42/41 x 44,000 GBP – 44,000 GBP) = 1,074 GBP if the rate at expiry is 0.9300. Then it would be more profitable to trade CFDs in this example, assuming 1AUD=0.5GBP.
If you are trying to decide whether or not to take up CFD trading or Spread Betting it is important to consider these factors. Take a look at the different brokers and their pricing structure in your country and the options they offer. Speak with your accountant and find out the tax implications and you may find yourself on route for a profitable year.