An effective alternative to spread bets

While spread betting is the most popular choice among many retail traders, more experienced traders often use contracts for difference (CFDs) instead. The distinction between spread betting and CFDs can seem small.

Indeed, many of the biggest players in both are the same firms (market leader IG has around 40% of the UK spread-betting market and 35% of the CFD market).

However, there are significant differences in charges, tax treatment and transparency that can make CFDs a more effective tool in some circumstances.

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What makes CFDs different?

Let's repeat our trade on the S&P 500, only using a CFD instead of a spread bet. First, instead of betting pounds per point, we buy a specific number of contracts with a set monetary value ($10 per contract in this case).

Second, we'll see that the spread offered on the CFD will be tighter: let's say 1,949.5 1,950.5 instead of 1,949 1951. That's because with a spread bet, the provider makes its money from the spread and doesn't charge commission. With CFDs, it also charges an explicit dealing commission perhaps 0.1%.

Third, spread bets have a fixed maturity date. The cost of financing a long position (in other words, paying for the money you are effectively borrowing from the provider) is built into the spread.

However, CFDs are open-ended and so can run for as long as you want. This means your borrowing cost depends on how long you keep the trade open, so you'll need to calculate the financing cost daily.

This is usually based on Libor (a key financial market interest-rate benchmark) plus a set margin (around three percentage points). If you short a stock using a CFD, you will pay a borrowing charge. This reflects what it costs your provider to borrow the stock to short, and depends on how hard it is to borrow the shares.

Lastly, when we place our trade on the S&P 500 through a spread bet, we do so without taking any foreign currency exposure. We make a bet in pounds on how much the S&P 500 will change. When we place a CFD trade, we are betting on a contract valued in dollars, so we're taking on sterling-dollar risk as well as the risk of how the index moves.

This can be either an advantage or a disadvantage, depending on what you want to achieve. Note that your CFD provider may also charge for currency conversion if you're trading CFDs on assets priced in foreign currencies.

Do understand that if you use a spread bet you still pay all these costs it's just built into the spread. With CFDs, the charges are more transparent and visible. Some traders prefer this others favour the simplicity of spread bets.

Transparency and tax

Some CFDs also differ from spread bets by offering an explicit link between the price at which you trade and the price of the underlying asset. With spread bets, providers set their own bid and offer prices.

While competition and regulation should stop them from taking too many liberties, you don't have complete transparency. However, CFDs for individual stocks are increasingly linked directly to the price of the underlying shares, with no increased spread added by the provider. These are known as direct market access (DMA) CFDs.

Finally, while spread-betting profits are tax-free, CFD profits are subject to capital gains tax. Losses on CFDs can be offset against other gains to cut your tax bill. However, CFDs are not subject to stamp duty, unlike trades in stocks.

Manage your risk with Turbos

Broadly speaking, CFDs are more suitable for larger deals and trades that you intend to run for several days or even a few weeks. Spread betting can be more advantageous for smaller, shorter-term trades and is also slightly simpler, which can make it a better choice when you're just getting started.

However, both spread betting and CFDs require careful risk management, particularly with regard to setting stop losses. As a result, you may prefer to start with products that offer similar leverage, but take care of the stop-loss element for you.

Also, if your experience is mostly in trading stocks, you may want to trade through your existing broker. Covered warrants is one alternative to options, but there are other listed products that provide some of the same features as CFDs.

One example is Turbos, issued by Socit Gnrale and listed on the London Stock Exchange. Turbos are issued with a fixed maturity date and a strike price. At maturity, a Turbo's value is determined by the difference between the strike price and the price of the asset the Turbo is based on similar to a covered warrant.

However, Turbos also have a knock-out price. If the price of the underlying asset drops below the knock-out at any time, the Turbo expires worthless.

This makes a Turbo similar to a spread bet or CFD with a guaranteed stop loss. You can lose all the money you first paid, but your loss is capped. The knock-out feature rules out the chance of the price recovering before expiry (unlike a covered warrant), but makes them more sensitive to changes in the underlying asset and so can mean more leverage.