Spread betting and contracts for difference: a beginner's guide

Contract for difference chart

Financial spread betting and contracts for difference (CFDs) are very similar. Both instruments allow the user to speculate on the price movement of the underlying asset (or stock, for example) without having to physically own the product.

Spread betting and CFDs are particularly useful during periods of high market volatility. This is because they are relatively quick to trade so you can react to market movements nimbly, even on your mobile phone if need be. You could also use these products to hedge against falls in your underlying portfolio.

So if you hold a physical stock, you can protect yourself against a downturn in the market by trading short, either against the same share, or shorting the index.

To see how it works, let's look at an example trade. Every product in these markets trade at a bid/offer spread - the offer is the price you can buy at and the bid is the price at which you sell.

SPREAD BETTING/CFD EXAMPLE

So let's say Company X is quoting a bid/offer of £1.59/£1.60. The penny difference between the two prices is, you've guessed it, the spread.

If you think Company X will rise in price, you might decide to buy 10,000 CFDs at £1.60. Note that if you went to your stockbroker to buy 10,000 shares of the physical stock you would be offered the same prices of £1.60.

You would write out a cheque for £16,000 (10,000 x £1.60) and pay a dealing commission of, say, £12 and £80 stamp duty at 0.5 per cent. So you are £16,000 out of pocket plus commission and taxes of £92, although you might get a nice share certificate and an invite to the AGM.

Going down the CFD route, you could do the same thing, with a difference: as it is a leveraged product, you only pay a deposit to open the same position and in this case it's, for example, 5 per cent.

So you deposit 5 per cent of £16,000 (£800) and pay a commission of £16 at 0.1 per cent. So your total outlay for the deal giving you access to £16,000 worth of Company X is £816, freeing up your capital to trade elsewhere.

RISKS

Here's where the big risk warnings come in - you'll see them on the adverts offering CFDs or spread bets.

You may have deposited £800 plus paid a commission, but you are exposed to a potential £16,000 loss if the Company X share price falls to £0. Unlikely, but anything is possible.

You have been warned.

That's where 'stop losses' can be very handy. At no extra charge you can inform your provider that if the price falls to, say, £1.55, to close your position, realising a loss of £500, as for every penny the share moves up or down you gain or lose £100. Which leads neatly into spread betting.

SPREAD BETTING

With spread betting you are doing exactly the same as the trade above, but you are betting in pounds per price point movement.

So if you bet £100 per point on Company X at £1.60, you are doing almost exactly the same thing as in the trade above whether you are buying 10,000 shares or CFDs, with one key difference: the spread bet provider will charge an extra spread, typically 0.1 per cent on the price so the buying price in this example would be £1.616. Bets are typically as low as £1 per point minimum.

On the taxation side, you pay no tax on spread betting and will not be liable for capital gains tax (CGT) on profits. CFDs differ in that you may be liable for CGT on profits if they exceed the annual threshold of £11,100 (2015/16).

This tax status contributes to the appeal of spread betting, but remember if you make a loss this cannot be written off against future liabilities, whereas with CFDs it can be. Seek professional advice if unsure.

Example: use a CFD to sell the Footsie

Let's hedge your share exposure by shorting the FTSE 100 with a CFD. The FTSE 100 live price is sitting at around 6770. If, for simplicity's sake, there was a one point spread you would see a quote of 6770/6771. Let's say you want to sell as you think it will drift towards the 6000 level.

You sell one contract at 6770, which is the equivalent of £10 profit for every point the index moves down. You place a stop loss at 6800 because you want to limit your losses in case you are wrong, to £300 (£10 x 30pts). If this were a spread bet you would simply have gone short at £10 per point.

If you are looking to secure £600 profit from the trade you could place a limit order to buy one contract at 6710, equating to a 60 point move and £600 profit.

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.


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