Contracts for Difference (CFDs) and financial spread betting have continued to experience strong growth, despite the recent down turn in the UK stock market, as both active traders and experienced investors have turned to alternative financial instruments. Institutions and hedge funds have utilised CFDs for more than ten years in the UK stock market as an alternative means of investment to traditional stocks and shares. With the introduction of the electronic order book in October 1997, stock lending and borrowing facilities were extended from marketmakers to other members, allowing the individual investor access to CFDs. As more people seek to take control of their own financial destiny, alternative means of investment continue to be embraced. Although still some way behind the mature US market, there has been a growing realisation that going 'short' as well as long are essentially two sides of the same coin, and short-selling is a legitimate and essential means of trading, in a market becoming increasingly difficult to profit from in the traditional sense. Stamp Duty of 0.5% on all UK share purchases has prevented 'day-trading' traditional stocks and shares from being cost effective; but both CFDs and spread-betting are currently exempt from stamp duty.
A CFD is an Over-the-Counter agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price of the contract, with reference to the underlying share, multiplied by the number of shares specified within the contract. CFDs are now the preferred means of investment by hedge funds in the UK over traditional dealing because of their low cost of dealing.
CFDs and spread betting are now the preferred vehicles for active traders, although they have somewhat different characteristics. But how do CFDs and spread betting compare? Both products allow the user to go short and also, being margined products, the user can gear themselves up, in other words, take an underlying position that is a multiple of his funds. For example, if the margin rate for Barclays were 10%, establishing a £100,000 position would only require a deposit of £10,000. Any running profits can be used as margin to establish new positions, however running losses must be made good by either reducing the position or providing additional funds. This gearing effect clearly demonstrates the importance of trading discipline and capital preservation. Too many times traders find themselves in a corner by over committing themselves too early and missing out on other opportunities that they would otherwise have been able to take advantage of.
CFDs do not have an expiry date and being a margined product, a daily funding charge will be applied to the account for long positions held overnight. Short positions attract an interest rebate. No funding charge is applied for positions opened and closed in the same day. Spread-bets on the other hand have a premium already built into the price and will generally trade above the underlying share price, somewhat similar to a futures contract, which has an associated 'fair' value based on funding charge until expiry and any dividends payable.
If you are in the UK and trade in sterling, there is no currency risk with a spread bet. Whatever the market you are betting on; be it the Indian stock market or the Japanese Yen/Swiss Franc exchange rate, your spread bet will still be quoted in pounds, as will all your gains or losses. Note that most spread betting providers still allow you to deal in US dollars or Euros so it isn't a problem if you're located overseas. Contracts for difference positions on the other hand are generally quoted in the currency of the market you are trading. Thus, if you are buying a Gold CFD, your position will be valued in dollars. This creates the inherent risk that a falling dollar will reduce your profits or magnify your losses.
CFDs are liable to capital gains tax at the investor's marginal tax rate after the annual allowance has been surpassed, while gains from spread bets are tax-free. This can cut both ways however, as although no one ever places a trade intending to make a loss, losses at some point are an inevitability. Losses incurred through spread-bets are gone for good, while CFD losses can be offset against future profits for tax purposes.
The most important factor of all is the bid-offer spread. A spread-betting firm posts its own two-way price like a bookmaker, a take it or leave it price. Most CFD providers however, allow you to post orders within the bid-offer spread enabling the individual to become a price maker rather than a price taker. The bid-offer spread is the most significant cost of trading and is the main reason why hedge funds use CFDs and not spread- bets. Access to the main market also means access to real prices and the pool of deepest liquidity. At some point the trader will need to exit the trade and may find himself disadvantaged by dealing with a counterparty that not only knows his position but can quote a price that may more suit the provider than the individual.
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As we have seen the cost of financing a CFD position, as well as commission, are not wrapped inside the spread, but are charged separately. Because of this, the CFD spread quote will always be very close to the underlying price of the share or commodity you are following. So one could that contracts for difference prices are more transparent than those for spread betting.
Essentially a CFD mimics every aspect of owning the underlying share or market without actually doing so. With contracts for differences, if you hold a long position you receive the benefit of any dividends being paid on the underlying shares. With spread bets you don't. Sounds good doesn't it? But it's a false benefit. You see, spread bets take into account the payable dividend that you're missing out on, and will adjust the price accordingly - so you don't lose out.
When trading contracts for difference, contracts are purchased in a similar way to purchasing shares. In other words, if you wanted exposure to 1,000 shares of BP, you would sell 1,000 CFD contracts at, say, 494p per contract. By contrast, with a spread bet you would place a £10 per point bet on the price movement of BP to hold the same position in the market. So you get an overall exposure of £1,200, but only pay £120 for that control..
The share price of Tanfield Group plc is now 32p-33p, and you decide to sell 100,000 shares via a CFD. The total contract value would therefore be £32,000. However, you only need to make an initial deposit of £3,200 (10% of contract value). If the shares fall to 20p your 'winnings' will be (32p-20p) x 100,000 shares = £12,000. You will have nearly quadrupled your money.
If, however, the position goes against you and the shares rise to 39p-40p, the value of the contract will be £39,000 and as such you will need to maintain your 10% margin. You will need to supply the broker with a further £3,900. If you do not provide the margin you will be closed out meaning that your entire loss will be (40p-32p) x 100,000 shares = £12,000.
Most CFD providers offer a guaranteed stop-loss service (for an extra premium) which will allow you to cap your losses to avoid such large hits.
For instance let's say that Andy, a 'day trader' believes that the FTSE Index has broken its support levels at 4800 points and takes a short position expecting the index to retrace back to 4700. Andy sells 1 CFD on the FTSE at 4800. With the margin requirement being say 1%, initial margin would be £48. Andy can hold positions overnight and if so he's eligible to receive or pay interest depending on his position. Since Andy is short on the FTSE and decides to hold the position overnight, he gets interest. Overnight margin requirements is the same at 1%. The next day the FTSE is at 4650. Andy has made 50 points and since he had one contract open he makes 50 pounds. With the margin set at 1% this would equate to 100x leverage.
Looking at the FTSE example above under a spread betting format. Suppose Andy thinks the FTSE will go down and bets £1 per 1 point movement in the FTSE going short. His margin requirement would be fixed to a set amount of pounds for every 1 pound he bets. So, for instance this could be £30 margin for every £1 pound bet. Again he holds the position overnight and receives interest. The next day Andy closes the position for a 50 point gain: since every point equals £1 pound, his profit would amount to £50 pounds. Very similar to the CFD position above with the only difference being that it is wrapped up as a bet - Andy could have placed a bet at £10 and a similar CFD trade would have been to trade 10 contracts.
Despite the debate, there is probably no right or wrong instrument to use; both CFDs and spread bets have particular features, which will appeal to individual trading styles. Choice will be determined more by trading strategy, the time the trade is held and the liquidity of the instrument. Some traders will trade a small universe of more volatile stocks, while others like to keep their options open and go to where the action is, trading both SETs and SEAQ stocks in an opportunistic manner. Whatever the instrument, the trader will encounter at least one of the following costs:
Probably the most important, although the least tangible as it doesn't appear directly on a contract note. Hedge funds however are acutely aware of its importance and consider it the most important execution cost. As an example, it is interesting to consider a contrary strategy. If a trader wanted to lose as much as possible as quickly as possible, he would continually hit the bid and lift the offer of the most illiquid instrument he could find.
It is important to quantify what you are getting for your money when you pay a commission. On-line execution-only dealing services that 'slash' rates from £10.00 to £7.50 are somewhat missing the point. It is possible to trade for free, but that comes with incurring a different cost.
Stamp Duty prevents short-term active trading from being cost-effective. However, some have recently compared it to inheritance tax - somewhat voluntary. Because no ownership of the underlying share is conferred, neither spread betting nor CFD trading attract stamp duty.
Trading on margin brings its own risks and demands additional discipline. However it also allows greater financial flexibility and freedom. Maintaining liquidity should also be a priority so that should a trading opportunity arise, the trader does not find himself 'out of the market', being over committed elsewhere.
All positions have to be funded whether traditional shares or CFDs. However the additional funding costs associated with CFDs are often over-stated. Assuming a margin rate of 10% and a funding rate of 3% over base rates the additional cost of maintaining the CFD is the extra 3% on 90% of the consideration. It can quickly be calculated that this additional cost reaches 0.5% of the consideration after about 77 days or 11 weeks. At that point, the additional financing cost of the CFD has overtaken the stamp duty saving, reinforcing the perception that CFDs are ideal for short-term strategies.
Often ignored (sometimes deliberately) is the cost of sitting in front of a screen. Unless fortunate enough to be financially secure, or to be able to pursue trading as a hobby, the full-time CFD trader ought to have some annual target in terms of return on capital. Spread betting is an excellent entry-level product where a stake can be anything from 1p a point upwards. However at some point a greater commitment may be sought. Most CFD traders trade in considerations of £10,000-£15,000 upwards (requiring a margin of £1,000-£1,500).
Borth spread betting and CFDs have become firmly established in the modern private investor's armoury of dealing instruments. Their flexibility and cost-effective means of execution are particularly attractive, but they are not a replacement or substitute for long term investment and saving. However with an ever-increasing number of CFD and spread betting providers offering a retail product encompassing both on-line and telephone trading, a competitive market has been established.
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