Spread betting vs. contracts for difference

THE new year is underfoot, and with European sovereign debt still looking problematic, Chinese inflation sky high and the Federal Reserve still emptying a bathtub of money onto the world, it is looking to be at least as interesting a year as 2010.

For ordinary investors, volatility is not very much fun. Most people are quite risk averse and don’t enjoy seeing their stock portfolio collapse in value one day, even if it does zoom back up again on the next. But one peculiar tribe of investors loves volatility.

They are a disparate bunch. Some reside in gleaming hedge fund buildings in the West End, while others lurk in dark bedrooms, but they are all brought together by their use of contracts for difference (CFD) and spread betting to make a profit whether prices are going up or down. If you’re considering joining the group, you may want to know the difference between the two trading systems.

CFDs and spread betting are very similar. They’re both derivative products, so investors don’t own the underlying product.

Many providers now offer both. The most important difference is in taxation. Spread betting is legally considered to be gambling, and so winnings are exempt from capital gains tax. On CFDs, it is payable, but losses can also be written off against profits made elsewhere.

According to Angus Campbell, of Capital Spreads, that is important. “For beginner investors quite new to trading, spread betting is the better option, because it’s practically the same and you don’t have to worry about tax.” CFDs however are “better for more sophisticated investors, who might be using them for hedging or other purposes”.

Which product is appropriate to who is thus highly dependent on your tax status.

If you have a large stock portfolio already, and you want to use derivatives to hedge against unexpected movements, then you will probably want to use CFDs, since you will be able to write off your losses on one side against your profits on the other.

If, however, you are more keen to trade simply to make a profit on speculating, spread betting makes more sense – although, as Campbell warns, “more clients lose than make a profit” with spread betting overall, so though no one will enter the market planning to get poorer, the apparent disadvantages of CFD trading could prove to be a boon.

Another reason to spread bet, however, is currency risk. If you are trading CFDs, you are exposed to any currency risk on shares or assets denominated in anything other than sterling, which can be difficult to mitigate. With spread betting, positions are all placed in sterling and adjust per point, and so even when trading on foreign equities, currency risk is not an issue.

Spread betting and CFD trading are both highly risky, derivative investments. Traders are not holding the underlying shares, and the chance to leverage up is impressive – the typical margin requirement on a CFD account is around 5 to 10 per cent of your total exposure.

That said, both offer retail investors the chance to do what hedge funds and large banks do every day – use derivatives to hedge larger investments and to speculate on price moves and to try to get an edge on the market.

For most retail investors, spread betting is probably the better alternative to CFD trading, but it all depends on your individual circumstances. With another year of tumult looking likely in most financial markets, however, there seems no better time to try one of the two.