The other day I was talking to what I’d call an “old-school” investor – the kind of fellow who swaps stock tips with his pals in the oak-panelled confines of his London club, before falling asleep between the pages of the FT.
I was talking to him about what he could gain from spread betting.
He looked horrified at the prospect.
I think that the only “betting” he’d ever done was through the tote at Royal Ascot.
His preferred vehicle was contracts for difference.
I often hear traders debating the differences between spread betting and CFDs – surely the dividing line between the two is more than a cultural prejudice?
First, let’s take a look at the similarities between CFDs and spread betting…
If you log in to two trading platforms – one for spread betting and another for CFDs, you’d be forgiven for thinking they were the same thing.
Both present prices as “bid” and “offer” on either side, and you can “buy” or “sell”, enabling you to make money on the downside as well as the upside.
In both cases, you’re not physically acquiring an asset – no shares are changing hands (which is why neither attract stamp duty). Instead, you’re either betting on how the price will move (spread betting) or entering into a contract that you buy at one price and sell at another, paying out the difference (CFDs).
The other thing they both have going for them is margined trading – allowing the trader greater access to the market than their trading fund affords – i.e. you don’t need to have the full value of the underlying shares to speculate on the value of those shares.
Where CFDs are taxing
A primary difference between the two vehicles is taxation …
Spread betting is gloriously tax free – no stamp duty and no capital gains tax.
Contracts for difference, on the other hand don’t incur stamp duty, but are liable for capital gains tax.
Of course, this goes both ways – with CFDs, you can offset losses against your tax bill. Not that I’m suggesting that we should enter into trading with the plan to lose money!
Why would anyone want to pay more tax?
With that in mind, you may wonder why anyone would use CFDs when they can spread bet tax-free. It’s a question I often ask myself.
Of course, there’s the elderly investor I was talking to last weekend – he has his reasons.
But more convincingly, it’s the prices that can attract traders to CFDs, especially if they’re using it in conjunction with direct market access.
Assessing the cost
CFD contract periods are flexible. Spread bets, on the other hand, have a fixed ownership period, where costs are incurred if you want to “roll over” to the next session.
Both products are margined, so there are financing costs for both: with spread betting this is built into the spread and the rollover charge; for CFDs there is usually a daily funding charge, with an interest rebate on short positions.
It’s important to bear in mind that the costs for a spread bet are bundled up within the spread. For CFDs the financing charges are applied separately, making the spread tighter – this suits some traders, not others.
Another point of difference is the way the trades are placed. CFDs trade a particular number of shares or “lots”, much like conventional trading of shares. Spread betting is done according to an amount of money per point.
Evaluating your relationship
This is where we get to the fundamental difference between CFDs and spread betting – and it can be tricky to grasp.
A spread bet company acts like a bookmaker, making its own prices, based on the actual market price. They may or may not hedge this position in the underlying market. The result of this is that the spread-bet company and the trader become sparing partners – one wins, the other loses.
While a spread-bet company is obliged to give clients best execution, a day doesn’t go by when I don’t hear about a trader who suspects they’ve been knocked out by their platform.
With a CFD, it is possible to use DMA (direct market access) – this means that you can enjoy the prices and liquidity that are identical to the underlying market. Here the relationship between the provider and the trader is different – more like a broker and client.
Direct market access can bring small improvements in execution prices, which, over time, can have a considerable effect on investors’ returns. The transparency allows traders to pinch a penny here and a penny there – making it suited to short-term scalping strategies.
In short …
CFDs can offer advantages over the longer term. Combined with DMA, they are a more dynamic and accurate tool with which to play the market than spread betting.
However, they are a more complex trading vehicle, and there are costs involved with direct market access. There’s also the cost of capital gains tax to cover.
I often hear CFDs described as the “professional” tool, compared to spread betting, which is disparagingly described as “for novices”.
I don’t hold with this. I’m not interested in paying tax that I don’t have to, which makes me a big fan of spread betting. As traders, it’s not often that we can get an advantage over big hedge funds, and the like – when one comes along, I don’t look it in the mouth!
In the next seven days …
If you’ve been speculating on BP, you’d better watch out next week, as boss Tony Hayward is planning a fight back.
Hayward will hold a strategy briefing on Tuesday, alongside the release of second quarter profits, which will show a strong year-on-year increase to about $5bn. He will also outline new drilling deals in Egypt, Azerbaijan and Libya.
Next week also sees some important housing figures released on both sides of the Atlantic, with the Nationwide house price inflation numbers, and new home sales in the US. The US figures are expected to be 12.7% down on a year ago – this has a significant knock-on effect in the economy because of all the costs associated with the purchase of a new home, in terms of goods and financial services.
Given the timing and impact expected off these numbers on Monday, it’s unlikely anyone will notice the Standard & Poors housing report on Tuesday.
If you’re a forex night-owl, you’ll probably want to watch for the Japanese CPI and industrial production figures on Thursday night – these could indicate a slow-down following a period of rapid growth.
Something else happening in Japan next week is the launch by Panasonic of a new 3D camcorder aimed at regular consumers – family movies may never be the same again!