A Beginner’s Guide to Spread Betting and Contracts for Difference

Traders these days do not always buy and sell shares directly. Many use spread betting or contracts for difference, particularly if they are short term traders wanting to take advantage of market volatility – buying and selling during the day or week rather than looking to invest for the long term, as do pension funds.

There are a number of advantages of these indirect methods, which we outline here:

• They enable you to trade on a much wider class of ‘asset’ than just shares, stock, bonds and currency. In essence you can trade on anything to which a monetary value can be attached, even initial public offerings (IPOs) before the real trading has taken place.
• You can use leverage – trade in a lot more than you can afford. A ‘margin’ of 10% for example would mean that you could buy £10,000 worth with only £1000 (a leverage of 10) and the gains would be correspondingly magnified when (if) the price rose – or vice versa. This means that you can effectively ‘play’ the markets without having to have enormous sums of money available but there are traps – you can lose a lot as well.
• There are commissions to be paid and buy-sell spreads to consider but you don’t have to pay taxes on the purchase. In the UK, there is a (small) tax called Stamp Duty that is paid when you buy a share in a quoted company and stockbroker commissions for ‘real’ shares. This makes it quite expensive to invest unless you have substantial resources.
• You can work on a falling market just as easily as a rising market. So you can hedge against adverse movement of price. If you are expecting $10k in a week’s time which needs converting into sterling, but the value of the dollar may well fall, you can open a short position on the dollar with a leverage of 100:1 for £70 (roughly the same value) which will pay you a profit if the dollar does indeed fall, so ensuring that you get about the same number of pounds in total. If the dollar rises you can close the position early if you want take a bit of a risk but the effect will be to stabilise the overall transaction for only a small investment. Foreign exchange leverage is generally higher than for shares because the prices are much more stable. The liquidity – the ease with which you can buy or sell – is also a lot better equities because there are so many people doing it.

You have to understand that behind the ‘real’ market there are of course market makers who do the actual trading. If you want to buy some shares in a company, you need to find someone to sell them – unless the company is issuing new shares. The purchaser (or vendor) hasn’t got a clue – s/he just says ‘Buy (or sell) 10,000 BP shares’ and expects the money to change hands immediately. If no-one is selling these in one go, the market maker has to put it together from lots of little trades, maybe at slightly different prices.   Trading is a really chaotic system and computers are a god-send to this industry.

Spread betting and Contracts for Difference appear to be very similar and for many purposes they offer much the same service.

Both are a kind of bet on the price of something – a company share, the price of oil or gold, the FTSE 100 or S&P 500 indices or the value of a currency for example. But rather than buying the share, barrel of oil, bar of gold or stash of banknotes, you are gambling on whether the price will go up or down. You do not have any direct relationship with the ‘instrument’ (as it is known), just its price.

The language is rather different – you don’t buy a share or place a bet, you ‘open a position’.

You can go ‘long’ if you expect the price to go up, or ‘short’ if you expect the market to go down.

The first case is quite like buying the underlying instrument but going short is as if you borrowed the instrument (bar of gold etc.), sold it and when the price goes down, buy the bar back and return it to the original owner, taking a profit from the fall in price. Coming out of the trade is therefore known as ‘closing the position’.

The trading platform will ‘hedge’ its net position – after all, if a more people open long than short dollar positions the platform will be short of money. So the platform will buy as many dollars as it needs but no more.

Both approaches are the same in that, the more a price moves one way or the other, the bigger or smaller will be your gain or loss. It is not winning or losing a fixed amount, such as with binary options.

But you can lose a lot – particularly with short trading. A price can increase theoretically infinitely – going against you – whereas it can only fall to zero if you are short. Sensible use of a stop-loss, where a position will close automatically if it goes outside a given limit, is therefore essential.

Online trading has now come to the masses and there are many excellent spread betting and CFD trading platforms available. Each of these has its characteristics and will offer slightly different prices.

So what are the main differences between spread betting and contracts for difference?

1)      Price. A Contract for Difference will mirror the actual price exactly (particularly if the trading platform has direct access to the market prices). A spread betting platform will be very close (sometimes almost identical) but will generally have a larger spread – the difference between buy and sell prices (we still call them ‘buy’ and ‘sell’ prices even if the action is to go long or short).

2)      Commission. Spread betting is generally commission-free, reflected in a larger difference between buy and sell. Contracts for Difference generally have a commission element and there is a gotcha here – the commission is based on the position, not the amount you invest! If you open a position of £10k-worth of shares in BP for example with a 5% margin, which would cost £500, the commission is paid on the £10k, not the £500. Moreover, commission is charged on open and close. This can be very expensive – my first foray into CFDs charged what sounded like a reasonable 0.5% commission. Translated, this meant that the stock had to move 10% for me to make a profit! I was naïve and soon closed that account!

3)      Expiration. Spread-bets generally have an expiration date, although you can roll them over. There are also roll-over fees (interest) for CFDs but they are generally smaller. For longer term investment, or hedging, people generally prefer CFDs as long as the commissions are small enough. In today’s low-interest environment, roll-over charges are not generally large.

4)      Dividend. An equity (share) that pays dividend will generally be subsumed within a spread bet – it is built into the price – whereas a portion of the dividend will be issued as a credit (long) or debit (short) to the account. A share price will fall a little when it goes ex-dividend (the previous owner will get the dividend, not the new owner).

5)      In the UK, betting is tax-free while gains such as from contracts are subject to Capital Gains Tax. While capital gains lower than a certain level are not taxed (currently about £10k), many people prefer to use spread betting for this reason, hoping perhaps to exceed the £10k!

It’s your call but generally people use spread betting for shorter term speculation, CFDs for mid-range investing and buy actual shares for very long term investment.

Do you have any experience with spread betting and/or CFDs? What are the main opportunities and dangers in your experience?

photo credit: JD Hancock via photopin cc