Should you consider CFDs?

Most investors who want to use leverage or to sell shares short begin by using spread betting, but this isn't the only option. More experienced traders sometimes use an alternative to spread betting called contracts for difference (CFDs).

These are offered by many brokers and spread betting firms. They work in a similar way to spread bets, but with some important differences that can make them more cost-effective in certain situations.

How CFDs 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 or other asset between the time that the contract is opened and the time that it's closed.If the share price rises, the buyer gets a payment from the seller. If it falls, the buyer pays the seller.

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Just like a spread bet, a CFD is a leveraged product, meaning that initially you only put upa percentage of the face value of the contract as margin (typically 5%-30%). If you place the same trade as a spread bet and as a CFD, the outcome should be very similar in terms of gross profit or loss.

So what are the differences? The most important is probably that the returns are taxed differently. On the one hand, spread betting gains are free of capital gains tax (CGT), but on the other your 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(ie, you're going short because you want to insure your portfolio against short-term turbulence, rather than explicitly to profit from a falling market) then it makes sense for the tax status of your portfolio and your trade to match up.

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

Clearer charges

There are also a number of differences in how you pay the costs of a CFD compared to a spread bet. If you trade a stock with a bid price of 649p and an offer price of 651p, your spread betting firm might quote you a spread of 648 652. So it builds its costs and profit into the spread.

A stock CFD, on the other hand, will usually be quotedwith around the same spread as the underlying stock (ie, 649 651 in this case) and you pay other costs directly.

For example, you'll usually pay a dealing commission every time you buy or sell, as you do when buying ordinary stocks. This is typically in the region of 0.1% for CFDs on stocks on the London Stock Exchange and other major markets.

While this commission is the most immediate cost you face, you must also 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 benchmark financial market interest rate) plus a set margin (around three percentage points is fairly standard).

For short positions, you pay a borrowing chargethat varies according to what it costs for your provider to obtain the stock you are shorting. The charge will vary depending on how hard it is to borrow the shares.

The fact that you pay extra charges on CFDs can make it seem as if they are more expensive than spread betting but that isn't the case. Using spread bets doesn't mean you avoid these costs it's just that the impact is built in to the initial spread.

With CFDs, costs are explicit and visible. Some traders prefer this transparency. Others especially those who are new to leveraged trading will find the all-in simplicity of spread bets easier to understand.

When CFDs can make more sense than spread bets

Tax treatment is usually the main factor for traders to consider when choosing between spread betting and CFDs. But there are other situations in which CFDs may be a better choice.

Spread bets have a fixed maturity date at which the position is automatically closed, while CFDs generally don't. You can usually roll over a spread bet when it reaches maturity, but you'll incur costs in the form of the spread between the closing price of one contract and the opening of another.

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

CFDs can also be useful for trading foreign stocks if you want the currency exposure as well as the stock exposure. Spread bets are usually placed in terms of a 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.

This means that if a US dollar-denominated stock falls 10% and the dollar rises 10%, your pay off depends only on the 10% fall, not on the stronger dollar. But CFDs are usually quoted in the domestic currency of the stock, meaning your profit or loss would depend on both the fall in the stock and the rise in the dollar. Depending on your view of what the stock's home currency is likely to do, this could be an advantage or a disadvantage.