CFDs: a tax-efficient alternative to spread bets

For most new traders, spread betting is by far the easiest and cheapest way to get started. But you may be better off looking at another kind of product, known as contracts for difference (CFDs). As the name suggests, a CFD is a contract between two sides where the payment is the difference in the price of a share (or another asset) between the time the contract is opened and the time it's closed. If the share goes up in price, the buyer receives money from the seller. If it falls, the buyer must pay the seller.

In most respects, CFDs are much like spread betting. They are a margined product, meaning you only put up a proportion of the potential value of the bet. The margin varies depending on which share you're betting on, but is typically 10%-30% of the contract's face value. And they are best suited to short-term trades of days or weeks, not months. When you go long on a stock through a CFD, you have to pay a daily financing charge to keep the position open (this is essentially interest on the money you're borrowing from your provider by only putting up 10% margin or so). Over time, this will mount up and eat into your return. If you go short on a share through selling a CFD, you are providing stock to the market and so you will receive a financing payment (at a lower rate than you'd have to pay it), but will have to pay a borrowing charge which reflects what it costs for your provider to obtain the stock for you to short.

Offsetting your losses against tax

So why choose CFDs over spread betting? The most obvious reason is tax treatment. Spread betting wins are exempt from capital gains tax, since they are classed as gambling. Gains from CFDs are not. For most investors, this sounds like a disadvantage and it is unless you have a strange compulsion to pay more tax than you need to. But the other side of the situation is that spread-betting losses are not deductable against tax, while CFD losses are. So if you have a large tax bill or complex tax planning, the ability to deduct losses may come in useful. For example, if you are trying to use short trades to hedge a long-term investment portfolio, it can be important to have the tax status of your hedge and your portfolio match up.

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There are a couple of other differences. For example, unlike spread betting, a CFD usually covers dividends too. That means the seller owes the buyer the amount of any dividends paid by the share during the life of the contract. This could be useful for certain trades involving high-yielding stocks or those paying special dividends. And bid-offer spreads on CFDs may well be more competitive than the spreads at most spread-betting firms, making them more attractive for high-volume traders. But generally speaking these derivatives are aimed at hedge funds, investment boutiques and high-net-worth individuals and will probably be of little interest to more casual traders. If you want to investigate further, most of the major spread-betting providers and discount brokers offer CFDs.

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Listed CFDs

Of course, the biggest obstacle in the way of trying out CFDs and seeing if they're useful for you is the need to set up a specialised dealing account. This typically has a reasonably large minimum funding requirement. So listed CFDs are a way to dip your toe in the water.

A listed CFD is a hybrid product half way between a CFD and a covered warrant. As the name suggests, they are listed on a stock exchange and can be bought through your broker with a normal share-dealing account. They have a fixed lifespan and a built-in stop-loss, with the maximum you have at risk being the initial amount you pay for the contract. And they come with the full tax deductibility of a normal CFD.

Sounds useful? Unfortunately, there are a couple of snags. First, listed CFDs have a feature called a knock-out barrier. If the price of the underlying share drops below this level at any point, the listed CFD expires worthless. Unlike covered warrents, it doesn't become valuable again if the share then rises above this price.

To understand how this works, consider a listed CFD going long on the FTSE 100. It has a strike price and a knock-out set at 5,400. With the FTSE at 5,700, the CFD trades at 35p. The FTSE then rises to 5,750, a rise of 1%. The price of the CFD goes up to 40p, a gain of 15% on your initial stake. This is around the same return you'd expect through a spread bet or a normal CFD, and a bit more than you'd get by using an option or covered warrant for the same trade.

But if the FTSE were to drop below 5,400, the CFD would expire and you'd get nothing, even if the index then recovered. The same would also apply with a stop-loss on a spread bet or normal CFD. But with those, you can choose where to place your stop-loss and move it around. With a listed CFD, it's fixed. Meanwhile, with an option or covered warrant, your trade would be back 'in the money' as soon as the index rose above the strike price again.

The other problem is that the range of listed CFDs is small. Socit Gnrale was the main provider trying to develop this product. The range it offered was never very substantial a year ago it was around four indices and seven equities and pricing wasn't very competitive, but it looked like things might improve. However, even SocGen now seems to have lost faith in the product: the current line up of contracts is down to four.

On the plus side, pricing seems to have got better and longer-dated contracts (with expiry dates out as far as December) have been introduced. So if you want to try CFD-style contracts without a CFD account, this is the way to do it.