Twin products for the skilled trader

Tom Welsh
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MARKET volatility is often a problem for investors. But some, with the talent and bravery to turn turbulence into a boon for their portfolios, make good use of a pair of derivative products – contracts for difference (CFD) and spread betting. How should you choose which to use?

Functionally, they are more similar than different. As derivatives, investors trade on live-market price movements without owning the underlying instrument. The idea is to predict market changes -- will one of 12,000 markets (indices, shares, forex and commodities) move in one direction or another?

With both, investors can short or buy into the market, to make simple profits or to hedge against losses in a wider portfolio. Joshua Raymond, chief market strategist at City Index (which provides both platforms), says spread betting and CFDs give investors “an immense flexibility and the ability to make profits, regardless of whether we are in a bull or bear market”.

Both are leveraged products and traders pay up-front a fraction of the total value of the contract. Returns on investment can be many times the initial stake and, concurrently, investors can lose far more than if they bought the underlying product at the same price.

The distinction between the products, therefore, isn’t that stark and some differences aren’t all that important. For example, although spread bets are commission-free and equity CFDs incur a charge, wider spreads under the former even out trading costs. But it’s still sensible to understand how each product might fit into your investment strategy.

The main difference lies in tax (or lack of it). While both are free from stamp duty, spread betting is classified as gambling and profits aren’t liable for capital gains tax (CGT). This, according to Raymond, allows spread betters to “save a double digit percentage on their net gains”.

But potential traders should consider how tax savings fit alongside their underlying motivation for using the products. Despite freedom from CGT, spread betting losses can’t be offset against taxable gains made elsewhere in a portfolio. CFD losses, in contrast, can.

Investors with large portfolios, seeking to conduct a short-term hedging strategy against expected changes in the market, will find CFDs more useful. The unencumbered speculator, with a confident prediction that the market will move in a certain direction, will find spread betting more attractive. Spread betting might also be the better option for a newer trader who doesn’t want to worry about tax.

Currency risk is another complication. CFDs expose investors to currency movements in trades denominated in anything other than sterling. Spread betting is conducted exclusively in sterling, even when trading a foreign product, and so calculations will be less complex.

The most important decision, however, may not be whether to take up CFDs or spread betting but whether either product is appropriate to your wider investment strategy. Stop loss orders aren’t always reliable, and overnight trades may incur charges. Most significantly, the typical margin is around 5 to 10 per cent of total exposure, so traders who can’t closely watch market movements risk significant losses.

These products offer the chance to take profitable advantage of market volatility. But investors must decide whether they have the appetite for risk, and sufficient time to take control of their trading, before they plunge into CFDs or spread betting.