Getting Market Leverage: CFD versus Spread Betting

Brief Overview

The chance to make large returns on investments in financial markets is always enticing. However, traders might not always have access to the capital that is needed to achieve these returns. Leveraged products provide an opportunity to invest in markets with only a small initial deposit to get substantial market exposure – a practice that is wildly popular with traders in the United Kingdom. Contracts for difference (CFDs) and spread betting are leveraged products that are fundamental to the world of equity, forex and index markets.

Key Takeaways

CFDs – or contracts for difference – are leveraged term derivative contracts that mirror the price of some underlying instrument and pay off accordingly.

Spread betting uses a wager to try to predict the direction a pointer will move over a contract on an underlying instrument that you do not own.

While the two are similar in principle, in reality there are several finer points that distinguish CFDs from spread betting.

CFDs

Contracts for difference (CFDs) are quite similar to derivative markets in that an investor takes a position on the final value of an underlying asset, relative to where it started, in a contract between the investor and a bank. Likewise, with spread betting, you put money on whether the market will go up or down, and the difference in price between when you open and close a trade is paid out in cash.

With CFDs, nothing is physically delivered to someone else – no goods, no stock certificates – but once the contract is signed it has the value of a tradable security while it is still in play. The CFD is simply the contract itself – the seller (the broker) is buying (the price you paid) and selling (the value projected when you close the position) the difference between what you agree to buy or sell, multiplied by an established currency value.

While CFDs provide an instrument to trade the price movements of futures contracts, other investors use CFDs to trade and speculate on the price movements of shares, indexes and other financial instruments. The distinguishing feature of CFDs is that they are not futures contracts, although they trade as financial securities with buy and sell quotes. CFDs don’t have expiration dates with predetermined prices.

Rather than on an exchange, CFDs trade over-the-counter (OTC), with prices and trades being set through a market-maker system of brokers who collate public demand and offer for CFD contracts on a specific asset.

(For related reading, see: Risks With Contracts for Differences and An Introduction To CFDs.)

For the most part, CFD trading is not allowed by law for American residents.

Spread Betting

With spread betting, investors can speculate on the price movement of many different financial instruments including stocks, foreign exchange, commodities, and also the yield on fixed-income securities. They are effectively betting on whether the market is going to go up or down from the moment they place their bet. They also decide how much of their money they want to put on each bet. With spread betting, the deal is billed as an activity that is free of tax and also free of transactional costs – so that an investor can speculate on markets both in bull and bear conditions. This individual, unsaleable bet is not transferable to anyone else.

The spread-betting company defines buy and sell prices for the clients who wait to place a buy order when they predict the market to go up or make a sell order when they are convinced the market is set to plummet. It might be called investing but spread-betting is nothing but a form of gambling.

Unlike investing, you needn’t wait till the market close to see the outcome of fixed odds betting But here’s the catch. You don’t have to actually wait till the market close to see the outcome of your fixed odds betting; any time you feel like closing the bet, you have the choice to take your money home and not allow the tail wag the dog by letting further losses wash away your hard-earned savings.

FSB is a margined derivative where the trader gets to bet on the price movements of all kind of financial markets and instruments such as equities, bonds, indices, commodities and currencies. Based on their predictions, an investor can get into either a long (as in buying a share in the stock market) or a short (as in selling a share in the stock market) bet depending on which way the market moves.

(For an in-depth discussion, see Understanding Financial Spread Betting and Top Spread-Betting Strategies.)

Similarities

CDFs and spread bets are leveraged derivative products whose values are based on an underlying asset. The investor has no ownership of funds in the underlying market. Trading in contract for differences is gambling on whether an underlying asset will rise or fall in appreciation in the future. CFD brokers contract with the bettors onto the underlying asset prices, where bettors can purchase to ‘go long’ as they expect the underlying assets to increase in the future, or bet against it, whereby they can ‘short’ sell, expecting the asset to decline in value. In both situations, the investor expects to gain the difference between the closing value and the opening value.

Likewise, a spread is defined as being the price difference between the quoted buy price and sell price offered by the spread betting company; movement in the underlying asset is measured in basis points, and the ability to buy long or short is afforded.

Margin and Mitigating Risks

Both CFD trading and spread betting require margins in the form of an initial deposit – margin ranges between .5% and 10% of the value of open position. The volatility of the asset will dictate higher margin rates for investors of the more volatile assets and less margin for more secure assets. While the investor contributing margin in CFD trading or spread betting pays only small percentages of the asset’s value, he is still liable to the same gain or loss as the investor who paid the full 100% of the value. Presently, both CFD providers and spread betting companies can call upon an investor at a later date a second margin payment.

Ultimately, risk can never be fully avoided in the world of investing, but making smart decisions to avoid the very worst losses of all root out a huge chunk of risk. The chance of making 100% of the profits in a CFD trade is the same as the chance of making 100% of the profit in a spread bet. However, the chance of losing 100% of the money in a CFD trade is the same as the chance of losing 100% zerof the money in a spread bet.

It is possible to place a stop loss order on either a CFD or a spread bet before the contract is initiated. A stop loss is a pre-determined price at which the broker will close your contract. This stop loss order can be placed very close to your take profit order so that you only profit if the market moves above the resistance level and hits your take profit target. In order to ensure that your CFD provider or spread betting company closes your contracts, both these types of companies offer guaranteed stop loss orders for an additional fee. (For more, see: Narrow Your Range With Stop-Limit Orders.

Main Differences

Spread bets have a fixed expiration date in which the bet must be closed at the time of opening, while a CFD contract has no expiration date. Another difference is that spread betting is carried out ‘over the counter’ (OTC) by a broker. CFD trades, in contrast, can be executed straight in the market. The basis of the transactions is over the counter, so there is no transparency of market […] The transactions are simple, and you can finish trades more easily when you trade with us.

With the exception of any margins established, a CFD trader also must pay the provider for each separate transaction, whereas a spread betting firm does not take any fees or commissions. Upon closing the trade and realising a profit or loss, the bettor owes or is paid by the trading firm a corresponding amount of money. If the trade is successful, the CFD trader’s closing position will have shown a profit from the opening trade’s price, less any fees incurred.

The profit on spread bets is the number of basis points the contract moved in the specified direction times the dollar amount agreed upon in the initial bet. Dividends from a stock are paid to the CFD trader (or short-seller) if in a long position, since even though the investor never owns the underlying asset a CFD provider or a spread betting firm will pay dividends if the stock does as well. If the investor realises a profit on a CFD trade, the investor will be subject to capital gains tax; however, spread betting profits are tax free. Here are some tips for trading CFDs in an emerging market. (For further reading, see: How Derivatives Work.)

The Bottom Line

Under the outer garment, both are similarly structured but with a fine nuance – nor is this necessarily apparent to the new investor: Commissions and stamp duties are not payable on spread bets, nor are profits liable to capital gains tax. (Madani)Unlike CFDs – see above – spread-betting profits are not liable to capital gains tax. Similarly, CFD losses are tax deductible, and traders use direct market access (Madani).Both involve real risk, however, and which of the two investments will maximise a return is only likely to be sensibly determined by the informed investor.