CFDs versus Spread Betting?

Active investors are often looking for effective ways of trading the markets, away from simply buying traditional equities. Spread Betting and CFDs are two vehicles which, instead of an investor actually buying a share, offer trading options which work on a derivative of the share price. They share certain similarities, both claiming to offer flexibility and access to a wide range of trading strategies. But what are the fundamental differences between the two? Which should an investor use in their overall portfolio?

Both CFDs and Spread Betting share similar characteristics, so how should investors decide whether they want to trade them, and choose between the two?

Both products allow the user to go ‘short’ i.e. sell, and also, being margined products, both can utilise leverage. However there are significant differences between CFDs and Spread Betting, and knowing the differences will help a trader determine whether one, both, or neither is right for them.

Essentially a CFD mimics every aspect of owning the underlying share or market without actually doing so. This has a number of advantages, but also some disadvantages.

The cost of financing a CFD position, such as commission, is not wrapped inside the spread, but is charged separately. Because of this, the CFD spread quote should always reflect the underlying price of the share or commodity you are following, as they wrap their spread around the market price. The spread from a spread betting firm however, is set by the firm in a similar way to a bookmaker, at a ‘take it or leave it’ price. This means that a CFD price is often much more transparent than a spread betting price, and takes away the ability for a firm to keep changing the spread or moving the goal posts solely to suit themselves.

This approach also means that some CFD providers and platforms offer Direct Market Access (DMA). This is an electronic trading facility that allows CFD investors a way to interact directly with the order book of an exchange, missing out the market maker. This gives the trader more control and is often combined with algorithmic, or ‘robot’, trading, to give access to many different trading strategies.

The bid-offer spread is often the most significant cost of trading. Controlling this cost is why hedge funds often use CFDs and not spread-bets, as the market controls the spread and not the company, so access to the market through CFDs means access to real prices. With spread betting, when the trader wants to exit the trade they may find himself disadvantaged by dealing with a counterparty that not only knows his position, but can quote a price that could potentially suit the company more than the individual trying to close the trade.

When trading CFDs, contracts are purchased in a similar way to purchasing shares. If you wanted to buy, say, 1,000 shares of an oil company, and did not want to buy these as a physical shareholding, you would buy those 1,000 shares through a contract at the price and then wait for the price to move. By contrast, with a spread bet you would place a certain amount; say £10 per point, bet on the price movement of the oil company. This means you are looking for how much the price moves more than what price it moves to.

The currency in which you place bets is another key distinction between CFDs and spread bets. With CFDs, your bet will be denominated in the currency of the underlying asset. So, if you are buying a Gold CFD, your position will be valued in dollars. If you are buying the Nikkei 225 it will be in Japanese Yen. This creates the inherent risk or potential reward that falling or rising currency rates will reduce your profits or magnify your losses. As spread betting uses synthetic prices, you will trade in Sterling in the UK, or Euros in Europe, using your home currency rather than relying on currency conversion prices.

Some CFD firms also offer advisory services, of which there are very few in spread betting. If you opt for an advisory account with a CFD firm, your broker can provide you with recommendations on what to buy or sell, which can help many market participants, though there is no guarantee an advisor’s performance will be more profitable. You should also bear in mind that advisory services will generally cost more in terms of commission or charges then trading execution only.

The structure of the market means that CFD traders usually have much greater resources than spread betting customers. This is because traders who want to take bigger positions want to be assured of getting their orders filled at a particular price. With spread betting, this is much harder, as the prices are merely derived from the market, rather than set by it. On big orders this makes a significant difference to serious investors.

Another difference between the two is that Capital Gains Tax is due on CFDs and not Spread Betting, which could add some extra cost to CFDs, although some traders would say that it is the cost of the approach they wish to take. A lot of investors also use CFDs for hedging purposes because they are liable for capital gains tax. This means they can be used to offset against taxable returns on previous years.

Trading CFDs or Spread betting is riskier than trading equities or other financial products, they are not suitable investments for everyone and are designed for traders with sufficient experience of the markets to understand the products and underlying investments they are trading on. Whilst both instruments enable traders to access greater flexibility and potential profit than other less risky products, the higher degree of risk can generate large losses in a short space of time. If you are considering trading either product, you should make sure you fully understand all the risks involved before you begin trading, and should only invest money you can afford to lose.