Risk and reward: Contracts for difference and spread-betting

These derivative products offer the potential for high returns but investors should tread carefully

MITIGATING risk is often high on an investor’s list of priorities. But for those with a higher risk tolerance – who use contracts for difference (CFD) trading and spread-betting regardless of whether the market is going up or down – market volatility is name of the game. If you’re planning to join this group, make sure you know your basics.

On the surface, there is little difference between CFDs and spread-bets. Both are derivative products, with investors judging whether the price of an underlying investment will rise or fall. Both let investors go long or short, and are leveraged products – so a small deposit may give investors significant market exposure to an underlying asset. And unlike traditional share trading, on derivative products investors won’t have to pay stamp duty.

But while CFDs tend to be linked to real assets such as shares, commodities or currencies, spread-betting “takes place on markets made across a far wider range of activities – for example the outcome of sporting events,” according to the Financial Ombudsman Service.

And although some investors will choose CFDs – a decision Joshua Raymond of City Index attributes to “spread-betting having the word ‘bet’ in it, and many people are afraid of gambling – spread-betting remains more popular in the UK. And the reasons are several.

Spread-betting – which allows investors to speculate on the price movements of thousands of financial markets and make profits or losses based on that movement – is legally considered to be gambling, which means any winnings are exempt from capital gains tax (CGT). As such, “spread-betting offers a tax efficient way to invest if you’re a UK resident,” says Mark Priest of ETX Capital.

It carries a far higher level of risk than traditional gambling, because it allows gains – or losses – of more than the original stake. When you spread bet, you do so on a margin, with consumers typically required to have between 5 and 10 per cent of the value of their open positions on deposit with the trading company.

But CFDs do come with financial advantages of their own. CGT is payable, but losses on CFD trades can be used to offset taxable gains made elsewhere in your investment portfolio.

A second differentiator can make spread-betting a more appealing option. Long CFD positions attract daily finance charges – CFDs left open overnight, for example, will result in a charge being levied on your account. So make sure you factor the daily funding charge applied into your calculations.

And consumers will rarely pay commission on spread-bets. The business’s charges are usually included in the spread. Quoted prices of CFDs, meanwhile, typically match the underlying market, and then the business will charge commission for carrying out the trade. But “capital gains tax exemption aside, the profit and loss of both is often very similar,” says Priest.

CMC Markets highlights a third differentiator: currency risk. The risk involved with trading CFDs, on shares or assets denominated in anything other than sterling, can be difficult to mitigate. With spread-betting, “positions are all placed in sterling and adjusted per point, so even when trading on foreign equities, currency risk is not an issue”.

So while spread-betting is more popular in the UK than the alternative, many investors will choose CFDs as a hedge against a physical, broader portfolio. With due diligence, hedges can be a powerful tool to protect your investments. But a short-term hedging strategy is a defensive move, and one that will reduce the prospect for striking greater profits. As such, Raymond would only recommend it at times of market volatility, when investors want to eradicate any risk, or when you’re on holiday and won’t be able to keep close tabs on your investments. “Hedging can give you peace of mind,” he says. So how would this work in practice?

Raymond gives a hypothetical example: “If you owned £5,000 worth of Vodafone shares in your portfolio, you could short sell the equivalent of £5,000 worth of Vodafone shares through a CFD trade. Should Vodafone share prices fall by 5 per cent in the underlying market, the loss in value of your share portfolio would be offset by a gain in your short sell CFD trade.”

CFDs are a straightforward way to hedge, but the key is in understanding the product itself, as well as the risks and the tools. Stop-losses, for example, ensure that a platform will close your position if the price moves against you and reaches a level you are no longer comfortable with. As with any investment, take sound advice, do your research, and only invest what you can afford to lose.