Investments in financial markets can reap large rewards. However, traders cannot always access the capital necessary to get significant returns. Leveraged products offer investors the opportunity to get significant market exposure with a small initial deposit. Popular in the United Kingdom, contracts for difference (CFDs) and spread betting are leveraged products fundamental to the equity, forex and index markets.
CFDs are contracts between investors and financial institutions in which investors take a position on the future value of an asset. Similarly, spread betting allows investors to place money on whether the market will rise or fall. Spread-betting companies provide buy and sell prices to potential investors who position their investments with the buy price if they believe the market is going up or sell price if they believe the market is due to tumble. Although fundamentally similar on the surface, there are many nuances that differentiate CFDs from spread betting.
CDFs and spread bets are leveraged derivative products whose values derive from an underlying asset. In these trades, the investor has no ownership of assets in the underlying market. When trading contract for differences, you are betting on whether the value of an underlying asset is going to rise or fall in the future. CFD providers negotiate contracts with choice of both long and short positions based on the underlying asset prices. Investors take a long position expecting the underlying asset will increase, while short selling refers to an expectation that the asset will decrease in value. In both scenarios, the investor expects to gain the difference between the closing value and the opening value.
Similarly, a spread is defined as the difference between the buy price and sell price quoted by the spread betting company. The underlying movement of the asset is measured in basis points with the option to purchase long or short positions. (For an in-depth discussion, see Understanding Financial Spread Betting and Top Spread-Betting Strategies.)
Spread bet, have fixed expiration dates when the bet is placed while CFD contracts have none. Likewise, spread betting is done over the counter (OTC) through a broker, while CFD trades can be completed directly within the market. Direct market access avoids some market pitfalls by allowing for transparency and simplicity of completing electronic trades.
Aside from margins, CFD trading requires the investor to pay commission charges and transaction fees to the provider; in contrast, spread betting companies do not take fees or commissions. When the contract is closed and profits or losses are realized, the investor is either owed money or owes money to the trading company. If profits are realized, the CFD trader will net profit of the closing position, less opening position and fees. Profits for spread bets will be the change in basis points multiplied by the dollar amount negotiated in the initial bet. Both CFDs and spread bets are subject to dividend payouts assuming a long position contract. While there is no direct ownership of the asset, a provider and spread betting company will pay dividends if the underlying asset does as well. When profits are realized for CFD trades, the investor is subject to capital gains tax while spread betting profits are tax free. (For more, see: Don't Let Brokerage Fees Undermine Your Returns.)
Margin and Mitigating Risks
In both CFD trading and spread betting, initial margins are required as a preliminary deposit. Margin generally varies from .5 to 10% of the value of the open positions. For more volatile assets, investors can expect greater margin rates and for less risky assets, less margin. Even though the investors in both CFD trading and spread betting only contribute a small percent of the asset’s value, they are entitled to the same gains or losses as if they paid 100% of the value. However in both investment strategies, CFD providers or spread betting companies can call the investor at a later date for a second margin payment. (For more, see the tutorial: Margin Trading.)
Risk in investing can never be avoided. However it is the investor’s responsibility to make strategic decisions to avoid severe losses. In both CFD trading and spread betting the potential profits may be 100% equivalent to the underlying market, but so can potential losses. In both CFDs and spread bets, a stop loss order can be placed prior to contract initiation. A stop loss is a predetermined price that automatically close the contract when the price is met. To ensure providers close contracts, some CFD providers and spread betting companies offer guaranteed stop loss orders at a premium price. (For more, see: Narrow Your Range With Stop-Limit Orders.)
The Bottom Line
With similar fundamentals on the surface, the nuanced difference between CFDs and spread bets may not be apparent to the new investor. Spread betting, unlike CFDs, is free of commission fees and profits are not subject to capital gains tax. Conversely, CFD losses are tax deductible and trades can be done through direct market access. With both strategies, real risks are apparent, and deciding which investment will maximize returns is up to the educated investor.