CFDs: A useful alternative to spread bets

Spread betting is a powerful tool for investors who want to be able to use leverage or short shares, but it isn’t the only option. More experienced investors sometimes make use of products called contracts for difference (CFDs), which are offered by many brokers and spread-betting firms.

These work in a similar way to spread bets, but with some key differences that can make them more effective in certain circumstances, especially for larger investors.

How they work

A CFD is a contract between a buyer and a seller in which the two sides agree to pay each other the difference in returns on a share between the time when the contract is opened and the time it’s closed.

If the share price rises, the buyer gets a payment from the seller. If it falls, the buyer pays the seller.

Just like a spread bet, a CFD is a leveraged product, meaning that initially you only put up a percentage of the face value of the contract as margin (typically 10%-30%). The gross profit or loss from the same position placed as a spread bet and as a CFD should be very similar.

So exactly how do CFDs differ from spread bets? One obvious way is in how costs are charged. Most spread-betting costs are implicit in the spread quoted by your provider. So, for example, if you plan to trade a stock with a bid price of 449p and an offer price of 451p, your spread-betting firm might quote you a spread of 448-452, building in its costs and profit.

By contrast, a CFD will usually be quoted with around the same spread as the underlying stock (ie, 449-451 in this case) and you pay other costs directly.

The most immediate of these costs is your broker’s commission, which you’ll pay every time you buy or sell. This is typically around 0.1% for CFDs on stocks on the London Stock Exchange, or other major markets.

Also, when you have a long position, you must pay a daily financing charge that represents the interest on the money you’re borrowing from the provider. This is usually calculated as Libor (a key financial market interest rate) plus a set margin (around three percentage points is fairly standard).

For short positions, you pay a borrowing charge that reflects what it costs for your provider to obtain the stock you short. The size of this charge will depend on how hard it is to borrow the shares and may be close to zero for large, liquid stocks.

It’s important to understand that using spread bets doesn’t mean you avoid these costs – it’s just that the impact is built into the initial spread. With CFDs, costs are explicit and visible. Some investors prefer this transparency, while others will prefer the all-in simplicity of spread bets.

CFDs versus spread bets: which are best?

New traders often ask whether spread betting or CFDs are the best choice. The answer is that it depends.

Spread betting is generally simpler for beginners. But for experienced traders (notably larger, higher-volume ones), CFDs may have the edge.

This is especially true with the increasingly popular direct market access CFDs, in which you set a price at which you are willing to trade and see if the market accepts it, rather than simply taking the quote your provider offers.

There are certain situations in which a CFD may be more suitable. One big difference between the two products is that spread bets have a fixed maturity date at which the position is automatically closed, while CFDs generally don’t.

Although it will usually be possible to roll over a spread bet when it reaches maturity, you’ll incur costs in the form of the spread between the closing price of one contract and the opening price of another.

This can make CFDs more cost-effective for longer-running positions, although you will still need to pay financing costs on long positions and borrowing costs on short ones while you hold the CFD.

CFDs can also be useful for foreign stocks if you want to take on the currency exposure. Spread bets are usually placed in terms of a certain amount of pound sterling per point, meaning that for shares priced in foreign currencies, you’re making a sterling bet on how much it moves in local currency terms.

So, if a US dollar-denominated stock falls 5% and the dollar rises 5%, your pay off depends only on the 5% fall, not the stronger dollar.

But CFDs are usually quoted in the domestic currency of the stock, meaning your pay off in the example above would depend on both the fall in the stock and the rise in the dollar.

Lastly – and perhaps most importantly – CFDs and spread bets are taxed very differently. Spread-betting gains are free of capital gains tax, but losses can’t be offset against gains elsewhere. CFD gains are taxable, but losses are tax deductible.

While this may sound like a huge disadvantage for CFDs, the ability to offset losses can be vital in certain situations.

For example, if you intend to put on a short position to hedge a long-term stock portfolio, it’s best to make the tax status of your portfolio and your trade match up.

If the portfolio is held in a tax shelter such as an individual savings account, a spread bet is likely to be more suitable, while for a taxable portfolio, a CFD may be better.