Contracts for Difference, Spread Bets or Covered Warrants?

The point of this round table is to help readers compare and contrast spread-bets, contracts for difference (CFDs) and covered warrants. With that in mind, we invited a covered warrant issuer, the managing director of a spread-betting company, and the head of trading at a small brokerage firm specialising in futures, options and CFDs. We then bolstered this trio with market professionals who make money by offering different combinations of the three main retail derivatives. None of the participants was paid money to appear on the panel.

Simon Denham
Job: Managing director, Capital Spreads.
Why he's on the panel: Former head of options at Cantor Index before setting up Capital Spreads, which specialises in spread-betting.

Foster Bowman
Job: Managing director, iDealing.com.
Why he's on the panel: iDealing is the only broker to offer all three of the retail derivatives. Worked as an options trader for Deutsche Bank before founding iDealing.

Angus Rigby
Job: Senior vice-president, TD Waterhouse.
Why he's on the panel: Works for a bank-owned discount broker offering shares, CFDs and covered warrants.

David Lake
Job: Head of listed products, SG Warrants.
Why he's on the panel: Helped launch covered warrants in the UK for Societe Generale, the world's biggest warrants issuer.

Paul Webb
Job: Senior dealer, Deal4free.
Why he's on the panel: Works for trend-setting spread-bet and CFD provider that runs its own book, in contrast to trading on market prices.

Charles de Roeper
Job: Head of markets and trading, Berkeley Futures Limited.
Why he's on the panel: Works for a firm offering advisory contract for difference dealing; knowledgeable enough about futures and options to assess covered warrants.

Tim Bevan
Job: Product and market development, London Stock Exchange.
Why he's on the panel: Tim helped to launch covered warrants; his brief covers all structured products; he used to work as a stockbroker for Tilney Investment Management, based in Manchester.

Which derivative gives me the most bang for my buck and why trade them?

Charles de Roeper, Berkeley Futures: We trade CFDs through the market - the price at which you trade is the market price and we guarantee best execution - so there are no added spreads to the position, although we do charge a commission. We are also a service company, therefore we are giving information and advice to the customer so it's in our interests for them to make money.

There is no real argument against spread-betting. They're very good instruments, which is why it's taken a lot of business away from me - not that I'm remotely jealous! But the downside is that you pay more in spread. And for frequent traders, that spread will eat away at your profit. Using a spread-bet to gain tax benefits is fine, or would be fine, if most gamblers made money. But most gamblers don't, so perhaps it would be better to use the exchange-traded product, which means that you could offset any losses.

With warrants - and even people who trade them will agree with you - the problem is that you can't go short. In my view, it's debatable as to whether it's a fair market to a customer if you can only get the benefits of buying a warrant, rather than the benefits of writing a warrant against equities that you may hold.

Simon Denham, Capital Spreads: To deal with the point about spreads, with Capital Spreads and, I imagine, Deal4free, the spread is pretty much the market price these days. On most equities, all we add is 0.05 per cent of the share price if you're holding the position open overnight - trading in the rolling daily shares. And 0.05 per cent is normally lower than the commission on a CFD. The difference between CFDs and spread-bets is now wafer-thin. I have to agree with Charles about covered warrants. They're expensive compared with options, and they seem to have none of the benefits. You can go short of options, and you can sell calls against a position you're holding - neither of which you can do with warrants.

David Lake, SG Warrants: To go back to the question, which derivatives give you most bang for your buck, there are two elements to that: risk and reward. And we're talking about two fundamentally different products. You have covered warrants on the one hand, which are strictly limited-liability products. The worst thing that can happen is that you lose the initial amount invested.

On the other hand, you have unlimited-liability products, such as CFDs and spread-bets. These can be compared to buying £100,000 Vodafone shares with your credit card, and then paying off the financial charges on your card. Hopefully, if things go well, and the markets rise, you get the full economic benefit of holding £100,000 in a particular share. But, if things go badly against you, you get that leveraged effect on the downside.

Tim Bevan, London Stock Exchange: The difference between spread-bets and CFDs is a tax decision, depending on what treatment you want as an investor.

Paul Webb, Deal4free: There's such a fine line between spread-betting and CFDs at somewhere like Deal4free. You trade on exactly the same product, the same gearing, the same risk levels, the same margin requirements, the same spreads, but there is no commission. The only difference is that to trade CFDs you need to be an intermediate customer, whereas for spread-bets you don't.

But if we're saying that CFDs and spread-bets are virtually identical - and for many providers they are - the fact that you have to be an intermediate investor for the CFDs and only a private investor to trade spread-bets is nonsense, isn't it?

Paul Webb, Deal4free: Yes.

David Lake, SG Warrants: There are two questions here. The first is: are there people trading risk products who shouldn't be? And I think the answer is definitely yes. You need to explain to retail customers that even if they are long of a position with a CFD or spread-bet, even with a stop-loss, and there is some market catastrophe, say a dirty bomb in New York and all markets open 50 per down tomorrow, do they realise that they could lose £50k, £60k, £70k or £100k on their position? And people say to that: "Doesn't a stop-loss protect me from that?" Well, no, because there is gap risk. I think that once people realise that potential risk, it can change their mind. The other question is: are people being pushed into trading these products by the providers themselves through their marketing schemes, without really understanding the risks? It's an interesting question. The Financial Services Authority (FSA) says yes, and that's why it fined two of the providers for not adequately disclosing the risks.

Simon Denham, Capital Spreads: The problem is - and this is something we see over and over again - because the client can gear up, he does gear up. If they were happy to spend £1,400 buying 1,000 Vodafone shares, they could get equivalent exposure using a £10-a-point spread-bet - that would mean putting down just £140. But the problem is that, if we give people margin to bet £100 a point, they'll bet £100 and then wonder why they lost all their money in four days.

Foster Bowman, iDealing: David presents a scenario in which all investors would be happier owning options, rather than what I'll call 'outright' products. But we could all benefit from a greater understanding of where these products sit. A covered warrant and an option are the same basic class of financial instrument. CFDs and spread-bets are a separate class, what the FSA used to broadly call 'contracts for difference' - they're a contract whose value is generally perfectly matched with some underlying instrument, normally a stock or foreign exchange.

Whether you choose spread-bets, CFDs or covered warrants, you should start off with the question: do I want an option, or do I want a contract for difference - an 'outright' product? If someone were looking for a broad guideline, I would say that it comes down to how much you think the underlying security is going to move. If you think that it's going to move by a very large amount, go for the option product. If you think that it may move, but not by much, go for the outright product. That's not an absolute rule, just a general guideline for those people struggling with a lot of alternatives.

Paul Webb, Deal4free: Some of the spread-bets and CFDs offer gearing of up to 100 times. That just shows that, if you've got £1,000 in your account, you can get £100,000 of exposure to the Footsie or Dow or the S&P. So you've got to be very careful about what you're doing.

Angus Rigby, TD Waterhouse: As a retail brokerage firm, we offer covered warrants and CFDs. We can position those as retail derivative products. I see no difference really between a CFD and spread-bet now that the line has really blurred, but it does have the word 'bet' in it, and we are an investor services company, not a betting company. It's not a moral issue - I've got no issues with spread-betting because I actually don't see any differences between the products. But when you're positioned as an investor-services company, you have to be careful about anything that has the word 'bet' next to it - and that's where bank-owned brokerages such as TD Waterhouse have a moral issue. They are asking what are you selling your customers? Is it a bet? It's called a bet.

Simon Denham, Capital Spreads: I had this argument with the FSA because it oversees spread-betting. And even though it is a bet, the FSA actually calls it an investment.

Tim Bevan, London Stock Exchange: It's mind-boggling that the tax treatment should be so different for what are identical positions. It's all historical - betting and financials used to be nicely divided. Now they have merged. It doesn't quite make sense any more.

Charles de Roeper, Berkeley Futures: But there's a very good economic reason for that because the chancellor would give away more in tax losses then he would gain in taxes on profits, and that's why it's done. It's the same with betting on the horses. The difference with futures is that they are exchange-dealt financial instruments, which are largely dealt by banks or financial institutions who will be taxed on their profits or losses.

David Lake, SG Warrants: The scenario a lot of investors may face is that they are confident that a share is going to rise by, say, 10 per cent over three months, and they want to know what instrument will make them the most money. And it all comes down to attitudes to risk. If you want to be sure that you can't lose more money than you put in, then look at a warrant or an option - although interest rates and changes in volatility can affect the warrant's price.

On the other hand, if you want absolute clarity in terms of what profit you can lock in if the price goes from x to y - albeit that you will have extra financing charges to pay and you will always have that risk of losing far more than you invested in the first place - then a spread-bet or CFD is something to consider.

Angus Rigby, TD Waterhouse: I do think that because of covered warrants, CFDs and spread-bets, UK investors have more choice than just about anyone else. Yes, in the US you've got choice through options and through futures, which have a much more retail focus. But you're not doing it all from one place in one account, which is what you can do in the UK now.

Paul Webb, Deal4free: We offer thousands of prices. You can trade Vodafone, T-bonds, oil, gold, indices, sectors, currencies, agricultural commodities... it's all there in one place.

We haven't talked much about how to use these derivatives in buy-and-hold investing because I have always assumed they wouldn't work. Either the financing costs of the CFDs are too high, or the rollover costs of the spread-bets stack up, or the time decay on the warrants is too long. Is that fair?

Simon Denham, Capital Spreads: There is a curious anomaly in that a spread-betting company takes the dividends out of any price. It means that the cost of holding a long-term spread-bet can actually be lower than buying the real share in the stock market, and taking the dividends in the normal way for a stock that pays a high dividend.

For example, imagine a person doing a forward quarterly spread-bet on something that has a high dividend, let's say Lloyds TSB. If you own Lloyds shares at 440p, and there's a 10p dividend, the shares are now worth 430p. So you will actually have made no profit, and you will have to pay 40 per cent, or 4p, of that dividend in tax. You will have lost 4p of your 440p over a dividend date. With a spread-bet, the forward price was 430p and, after the dividend, it's still 430p, so you haven't lost that 4p dividend.

There is a point where that crosses over, where the dividend goes below something like 2.7 per cent yield so, especially for a long-term holder, spread-bets have almost the same costs as buying the real product.

How does that contrast with the way dividends work with CFDs and covered warrants?

David Lake, SG Warrants: If you hold a covered warrant on Lloyds at 440p, the warrant is priced as if it were 430p. So when it goes ex-dividend, the price of a call warrant - and, most importantly, the price of a put warrant - stays where it was. If it didn't discount the dividends, all of us would be buying put warrants just before the stocks went ex-dividend, and we would be having this conversation in the Bahamas.

Suppose you hold a CFD on a share that pays out a 10p dividend. If you're a top-rate taxpayer, are you now liable to pay 40 per cent of that as a capital gain, or 32 per cent as dividend tax?

Foster Bowman, iDealing: The Inland Revenue put out some guidance to the effect that all costs that go into entering and exiting a CFD should be bundled together as a capital gain or loss.

Are there any other points to make with respect to using derivatives for longer-term strategies?

David Lake, SG Warrants: I would say that the financing costs of a CFD make it ludicrous to hold it over the long term. To go £100,000 long of the Footsie with a CFD, you're sometimes paying 3 per cent above Libor (the London inter-bank offer rate), or roughly equivalent to UK base rates. So that's 8 per cent a year. Even if the Footsie goes sideways for a year, you pay £8,000 for the privilege - with 100 per cent of the upside and 100 per cent of the downside. Why not close down your CFD account, use your credit card - which gives you zero per cent - and go and buy your shares through your stockbroker?

However, if you bought a warrant or a one-year at-the-money call option, the price of that would be about £8,000. That gives you exactly the same economic exposure on the upside - so you can have 100 per cent of any rise in the FTSE, but you get zero exposure to any fall. If you think about the impact of your financing fees with a CFD, you can find that, for exactly the same cost, you can have a radically different risk profile. And, in my book, you'd be mad to take 100 per cent upside or 100 per cent downside when, for exactly the same cost, you could receive only the upside.

Charles de Roeper, Berkeley Futures: If you go long with a CFD, you're still going to get the dividend paid in cash to you, which will offset some of the carry costs.

Simon Denham, Capital Spreads: You must remember that with a warrant, it was 8 per cent on the forward price, which was 5 per cent higher. So the CFD will cost you 8 per cent from this moment in time whereas, with the covered warrant, you're buying it on a price that is 5 per cent higher in the first place, with the full cost of the future.

David Lake, SG Warrants: The price of a warrant isn't based on the forward price. You will have the right to buy the Footsie at its current level.

Simon Denham, Capital Spreads: But the price wouldn't be 8 per cent because every Black Scholes computer would calculate that, if the forward price of the Footsie is at 100, a one-year option will be priced at-the-money at around 105 - or 104.75, if UK base rates stay round 4.75.

We've mentioned already that an investor cannot short-sell a covered warrant - what harm does that actually do an investor?

David Lake, SG Warrants: The FSA's position is that it cannot allow covered warrants to be sold short. It's something that we would prefer to do. What it means is that you cannot perform some strategies, which you can with Liffe-traded options.

One of the queries often directed against covered warrants is that they can be more expensive than identically structured Liffe options, and that sometimes can be true. Covered warrants are designed for broader retail investors who often otherwise wouldn't have the access, either because of the costs involved, or because they don't want to get into the complexity of trading Liffe options.

Foster Bowman, iDealing: Can I give you iDealing.com's perspective as a provider of all three products? The answer is that the cost of buying and holding a covered warrant - which is an option - for the lifetime is often more expensive than an option of the sort that could be bought through an options broker, such as Charles' firm.

That is true - in many cases, they are more expensive. For buying and selling in and out of the covered warrant, however, the covered warrant offers spreads that are tighter in many cases than the exchange-traded equivalent. So, if a client were to ask my advice and say "I want to buy a call on Vodafone, and I plan on selling it this afternoon, which one should I do?", it's quite possible that we could demonstrate that the covered warrant bid-offer spread, which is the lion's share of the transaction cost, is tighter than the exchange-traded option for Vodafone. If he said, "I want to buy a September call and hold it until maturity," you would probably find that the exchange-traded equivalent exposure on Vodafone is cheaper.

Tim Bevan, London Stock Exchange: It's an important point to make. It is a different commercial model. Options are a supply-and-demand market, trading at pretty much fair value. Warrants are provided, and there's a premium to that because there's the guaranteed two-way price, there's accessibility, there's the range of products and tighter spreads.

Spread is everything to a regular trader and, if you've got a tighter spread, you've got a better trading product. If you think of the full round-trip costs, and what you want to achieve as a regular trader, warrants are not necessarily more expensive.

Foster Bowman, iDealing: I would challenge anyone to find a covered warrant listed on the London Stock Exchange with exactly the same terms as an option on the Liffe market that has a price below that of the Liffe market.

That doesn't mean that you shouldn't use covered warrants, because covered warrants have great, very tight bid-offer spreads. But it's a mistake to try to obfuscate the fact that there is a premium in the covered warrants market compared with the options market. That is a fact. I'm not saying that it's not appropriate. It just is. So if you have access to a Liffe option, and you have a covered warrant, don't buy a long-dated option in the form of a covered warrant. You should buy it on the exchange. However, if you want to trade options in and out, we have found that, in many cases, the spreads on the covered warrants are tighter than the Liffe options.

David Lake, SG Warrants: The tightest spreads on warrants are generally offered on the Footsie products because we run a huge Footsie book globally, so we can offset the flow and offer extremely tight spreads. Compare the spreads on the FTSE 100 products, and you'll see that a warrant priced at 10.9-11.0p with a parity of 1,000 is equivalent to a spread of one index point, compared with two or four index points with a spread-bet or CFD.

Foster Bowman, iDealing: The spread on that Footsie warrant is really tight. Comparing that with an at-the-money call option with three months left, what would you expect?

Charles de Roeper, Berkeley Futures: The market would probably show 3-5 points, but you would probably deal at about 1.5-2 points.

What guarantees are there for the different types of derivative that you will be able to exit that position if markets turn fast?

Charles de Roeper, Berkeley Futures: For traded options, the answer is none at all. I remember 1998, when you had problems in the Far East. Option premiums went through the roof, and you were buying back options that were 200 points in-the-money at 300 or 400 points because the market maker didn't know whether he could offload them in the next five minutes because markets were moving so quickly. You can have an absolute disaster, which is where the customers need to be careful about it.

David Lake, SG Warrants: But with a covered warrant, we have to guarantee a two-way price at all times and, when you're trading other types of products, there is no guarantee that if you ever really have to get out - even if it only happens once - that you will be able to. The fact that you can get out with a covered warrant surely will make you feel more comfortable.

Simon Denham, Capital Spreads: Well, we're being a bit holier-than-thou. If we had another 11 September 2001 disaster, how many covered warrant issuers, notwithstanding what they said to the LSE, would put two-way prices up if they had no idea where the market was?

Tim Bevan, London Stock Exchange: If they failed to do that, then the investor would have regulatory recourse.

Would the issuers still have to stick to the normal rules on how wide spreads can be?

Tim Bevan, London Stock Exchange: There is provision for a more-than-fast market. Otherwise, the LSE's rules for warrant issuers are that they must put up a minimum size of 10,000 a side throughout the trading day, from 8.15am to 4.30pm. Spreads are set at a maximum of 10 per cent, or 1p spread, whichever is higher.

Foster Bowman, iDealing: At least you know about it - the investor can rely upon it. We're not saying it's bad that warrants are more expensive than options because providing guaranteed liquidity will cost more.

David Lake, SG Warrants: In effect, you pay a little bit extra on top of what you would pay on Liffe, knowing that you'll be able to get out of your position with a warrant.

Charles de Roeper, Berkeley Futures: It's quite similar in a way to the spread-betters and CFD providers who offer guaranteed stop-losses and charge a premium for that trade. You're giving a guaranteed product and there is a charge for that, just as there is with spread-betters.

Simon Denham, Capital Spreads: The problem with the guaranteed stop-loss - and I can accept it if the individual client wants to do it - is, of course, that some of the spread-betting companies enforce guaranteed stops on selected clients. And the point of enforcing a guaranteed stop-loss is that you charge them an extra two or three pips every single time they trade.

That's what happened when I first tried to trade foreign exchange. The spread-betting account that I used set me up with guaranteed stop-losses on sterling/dollar with an eight-pip spread, as opposed to three pips for the standard bets.

Simon Denham, Capital Spreads: That means the market has to move 9p in your favour before you make 1p. Companies will do those kind of deals all day long with thousands of clients in the knowledge that a guaranteed stop, with a market that is open 24 hours, is a worthless piece of paper because the market's open 24 hours, and they quote at 24 hours.

So there's no risk of the market gapping down?

Paul Webb, Deal4free: About 90 per cent of our stops get filled at the level anyway, and almost the only time you don't get filled is if there is movement overnight when the markets are closed. So imagine that you're trading Vodafone, and the telecoms sector in the US comes off when you've put your stop in five points away. The stock opens 10 points lower, so your stop gets filled in accordance with the underlying exchange. With a 24-hour market, there's no need to use a guaranteed stop-loss because they're the most liquid markets in the world anyway.

Simon Denham, Capital Spreads: And they don't allow you to be very close. If you trade US stocks with most spread-betters, they won't allow you to put your stop closer than 10 per cent away. But it depends what kind of trader you are. If you're a day trader, you don't need a guaranteed stop on a day trade.

Paul Webb, Deal4free: Or if you're trading 24-hour markets.

What about if you're trading something like Marconi, which has just collapsed again?

Simon Denham, Capital Spreads: Marconi just fell 30 per cent but, with a stock like that, you probably wouldn't be allowed to put your stop closer than 15 per cent away anyway. It would have cost you another 1 or 2 per cent to put the guaranteed stop on. So, fine, it would have saved you another 13 or 14 per cent of that fall, but then you pay the extra spreads for every other trade when it wasn't needed.

Charles de Roeper, Berkeley Futures: I think on UK equities, they're a brilliant idea. On the big markets, they're not. Any firm can halve in value overnight. But it's very rare that a commodity or currency does.

How do companies hedge their guaranteed stops?

Charles de Roeper, Berkeley Futures: Out of their profit!

Foster Bowman, iDealing: There's a required-capital provision from the FSA. You have to put a big chunk of capital against it - it's insurance.

Simon Denham, Capital Spreads: They know very well that the average trader trades five times a day, and they will actually require a guaranteed stop perhaps once a year. I know that some spread-betters used to buy way-out-of-the-money options, and the margin from the guaranteed stop-loss pays for that option 20 or 30 times over.

David Lake, SG Warrants: From a retail investor's point of view, they want to get involved in derivatives because of the great leverage. On the one hand, I can use a covered warrant because I know what my risks are. If I choose a CFD or a spread-bet, I have to put in a stop-loss, but the problem with stop-losses is that you're still exposed to gap risk so that if markets open down, they don't actually limit the amount of money you could lose. They can do guaranteed stop-losses but, as we were saying, maybe they are just too expensive, and they're running against the reason why you were putting on the position in the first place.

Many spread-betters make money from customers setting up stop-losses that are then breached. The spread-betting company closes out the position, and says 'thank you very much' that money is now mine. But stock markets are naturally volatile, stocks will very often recover and the investor loses out. With a covered warrant, though, its value can plummet one day, yet still recover later on.

Tim Bevan, London Stock Exchange: Yes, you are still in the market. It all comes down to that basic distinction between option-style products and what Foster termed 'outright products'. You've got to make that call early on.

David Lake, SG Warrants: What's quite nice about a covered warrant is that you have defined risk so that, even if the market were to collapse and the warrant were to become close to worthless, you still hold it so you still have exposure to the upside right through to the expiry of the warrant, which could be six, nine or 12 months away. It's just a much more forgiving way to trade because you still have a chance of being right until the end of the product's life.

Simon Denham, Capital Spreads: With warrants, don't forget that you have to be long of volatility - you have no choice. You cannot use warrants to say, "I don't think anything is going to happen". And what can often happen is that the market might go in a client's favour but, if volatility collapses, he can lose money.

David Lake, SG Warrants: The client needs to understand with options or warrants that there are other factors that can affect the warrant price other than the underlying, the most important of which is volatility. But it's not too dissimilar to investment trusts, which trade at a discount to net asset value (NAV), which can widen or narrow. You may buy an investment trust because you have a view on the underlying asset, but it could be that the underlying goes up while the discount to NAV widens, and you don't make any money. It's just a risk of that type of instrument. And that's how we explain it. It's important to realise that you don't need to understand all of the pricing components of warrants to trade them - you need to be aware that there is a risk that the price can change, even if the underlying doesn't.

This article originally appeared on Investors Chronicle Magazine