Tag: CFDs vs

Perhaps the best benchmark for comparison of the features of CFDs is share dealing in the traditional sense. When we think of investing, our default position is to imagine the trader buying and selling shares on a straightforward, pound-for-pound basis, cashing in on the difference between the price on the day shares are bought and that on the day they are sold.

In reality, the markets are much more complex, with a wide range of tradable assets on offer, of which CFDs are but one. So how do the two compare, and what are the specific characteristics of CFDs that lend them as an instrument class to profitable trading?

Trading and Leverage

The obvious key advantage with CFDs over straight share dealing is the leverage effect. Trading on margin, CFDs allow traders to take an often-vast exposure to a position without the need to stump up all the required cash. This serves to boost the earnings potential of any given trade, while also equalling increasing the risk profile of taking a particular position.

With share dealing, trading is conducted on an unleveraged, non-margined basis, limiting the profit potential of a single trade (and indeed the exposure to risk). Thus, share dealing represents the more conservative trading form of the two, with CFDs allowing traders to stack up behind sure-fire positions to increase earnings.

The Ownership of Underlying Assets

Another difference between the two lies in the rights being traded. With share dealing, investors are buying assets with an inherent value and yield in their own right. Shareholders are entitled to vote on strategic decisions affecting the future of the company, and are entitled to a regular dividend payment from corporate profits. As a CFD holder, your have no such entitlement, because you don’t in fact own any of these rights. However, CFD brokers will still reflect dividend payments and other corporate actions by factoring these in to the value of the CFD positions you hold, ensuring that your positions benefit from corporate goings on in spite of your lack of corporate ownership.

Tax Treatment for CFDs and Stock Trading

When deciding whether to trade CFDs or shares, the differing tax treatment of the two instruments must also be factored in to any calculations of cost efficiency. CFDs are exempt from stamp duty, charged automatically on share transactions at a rate of 0.5% of transaction value. However, CFD positions can be more expensive in the long run as interest and higher transaction costs take hold, and it depends on the nature and length of the position you wish to take which will work out most cost effective.

Thankfully, contracts for difference and trading in simple shares are not mutually exclusive, and savvy traders tend to employ a degree of both across their portfolio to diversify risk and make the most of the different trading options available to them. That said, it’s advisable to have a strong grasp of the pros and cons of each form of trading at your disposal before settling on one or the other for a particular transaction, and by employing CFDs and share dealing in tandem as part of a wider strategy, it can be possible to secure the advantages contributed by both instruments to maximise your trading income.

Contracts for difference and spread betting are amongst two of the most popular trading methods in the UK, accounting for a considerable proportion of individual and private trade. Not permitted stateside as a result of securities regulations, the two are examples of the ingenuity of financiers to create trading platforms which offer investors the means to speculate on the movements of virtually any market or index, and provide opportunities for the trader to leverage his expertise without actually exchanging any underlying assets.

Indeed, the two have a number of similarities. Both are highly leveraged types of trading, which can deliver multiple times the initial position in profit with absolutely no upwards limit on earnings. Both deliver economically similar results, steering largely clear of the market and provide traders with practically the same financial effect, and both are notorious for being particularly risky, with the ever present threat of unlimited down side liability.

Tax Difference between CFDs and Spread Betting

But it’s where CFDs and spread betting differ that really matters. Firstly, and perhaps most importantly, financial spread betting carries a considerable tax advantage in situations where it does not provide the trader’s mainstream of income. Because spread betting is regulated in the UK as a gambling activity rather than an investment activity, and no assets (which include tradable instruments) are actually changing hands, capital gains tax is not payable on the profits from spread betting – with contracts for difference, that’s not the case.

CFDs do attract CGT liability, although like financial spread betting they remain exempt from stamp duty, thus providing a means of accessing securities without the need to incorporate the relevant 0.5% liability – a saving that is of particular use to larger investors. Similarly, losses from trading contracts for difference can be carried forward and applied in relief against future trading profits to reduce overall liability on your trading income, whereas spread betting doesn’t benefit from any such relief, for the same reasons as it enjoys exemption from CGT.

More on Financial Spread Betting vs CFD Trading

Aside from the tax issue, there are also points of difference to be highlighted in the way in which pricing is pitched to the investor. In spread betting concern is cast to the number of PIPS in movement of a position, with PIPS X STAKE providing the profit component. With CFD trading, positions are quoted in a manner more akin to share dealing, with traders in a position to take either a long or short position on the market in a way that is almost indistinguishable from other types of share dealing.

Furthermore, CFD brokers on the whole tend to derive their profit from transaction fees, charging a percentage of the margined total position in addition to interest fees for the leverage provided. In contrast, spread betting brokers normally make their profits from the spreads they build in, reflecting a certain number of pips in every trade which ensures a portion for the broker whether the markets move up or down. For many traders, the latter proves the more attractive option of the two, preferring to pay out of earned profits rather than footing the bill in the form of commissions up front.

While spread betting and contracts for difference are similar in a number of key ways, they nevertheless have their differences in characteristics and style, and the advantages of both make them more or less amenable to particular trading situations. Regardless of the most appropriate option for the given trading scenario, both spread betting and contracts for difference equip traders with the ability to ramp up their earnings potential from single trades, while providing some degree of tax advantage over regular share trading.

Contracts for difference and futures on the face of things seem like rather similar instruments, which both providing the trader with a price tie in to be crystallised at some future point to realise a profit. Both are derivative instruments – that is to say, secondary instruments traded on the strength of underlying markets or indices – and both can be highly leveraged to maximise the earnings potential of a given trade. But in spite of their apparent similarities, CFDs are actually vastly different to futures contracts, and their contrasting characteristics should be factored in when considering which instrument is best for a particular trade.

Where Are Futures and CFDs Traded?

Firstly, CFDs tend to be largely traded off-exchange, with the broker being the second party to any transaction and any profits and losses arising paid by and to the broker orchestrating the deal. This means that the range and scope of CFDs on offer is determined by the individual broker, and there is little rigid uniformity across different brokers as to pricing and the markets they offer. Futures on the other hand tend to be traded on futures exchanges, meaning they are readily tradable amongst other investors and directly reflect underlying market movements in the assets to which they relate.

Expiry Date for CFDs and Futures

The second core difference between the two instruments is that contracts for difference are open-ended and can be held for any length of time (insofar as the costs of maintaining a highly leveraged position permit. Futures are sold with a specified maturity date on which they are exercised, giving less flexibility to the trader and giving rise to the phenomenon of price decay as their value shrinks in the run up to the point of expiry.

Cost Difference

Another obvious difference between the two instruments is the lower price entry point of trading contracts for difference, afforded as a result of their highly margined nature, versus futures which require a higher level of trader investment up front. While this isn’t necessarily an advantage for CFDs given the need to maintain and fund margin requirements for leverage, it does make CFDs a more attractive proposition for less experienced traders looking to get a low-cost foothold in this type of market.

What both instruments have in their favour is the ability to call and profit from future outcomes without actually having to invest in the underlying asset, and this form of derivative trading allows natural leverage to increase the potential gains from positive price movements.

Consider the example of a 5% rise in Company X’s share price. This rise will in turn lead to a proportionately higher rise in the value of futures contracts, for examples sake, where momentum suggests underlying shares may continue to rise over time. This effectively ensures the trader can profit at a greater level than would be the case with straight-forward investing in the underlying stocks, and particularly in the case of contracts for difference the heightened leverage potential only serves to exaggerate the potential gains even further.

Conclusion

Getting to grips with the nuances and the pros and cons of different trading instruments is essential to building a solid portfolio, and while futures and CFDs do bear a number of notable similarities it’s important to remember they are fundamentally different products, with fundamentally different characteristics which may lend themselves more closely to specific trading scenarios.

CFDs and options bear a number of similarities, but also a number of key differences, and both are suited to their own particular purposes. Unlike share dealing, where traders are engaging in the underlying asset, options are also derivative instruments which in themselves are naturally leveraged. That said, there are several notable differences around leverage and the actual pricing of the instruments that distances any similarities, and while at first glance the two may appear to be similar there are a number of important bases for comparison.

While contracts for difference are agreements to close out a contract for the profit (or loss) in the difference between the opening price and closing price of an instrument, options are simply rights to later purchase shares or commodities at a set price.

Options are bought at a fraction of the underlying asset price, and give the trader the right to later acquire the asset if he so chooses – usually, where it proves profitable to do so. The profit portion for the trader comes in later exercising his options when the market for the asset concerned rises – thus Profit = Selling Price – (Buying Price + Option Price).

Options Features

In terms of practical differences, firstly the transparency of instrument pricing differs greatly between CFDs and options, with CFDs being a more accurate tracker of underlying markets than options for a number of reasons. Options suffer, in the same way as futures, from a decline in their price point as their expiry looms, and indeed it is only logical that this would be the case – the value of the right to buy the shares is, after all, less valuable with less time to exercise that right in your favour before it becomes void, thus it is often harder to get a gauge of whether an option represents true value and a fair reflection of the underlying asset market.

Contracts For Difference Features

CFDs on the other hand, particularly those marketed by direct access brokers, track the underlying market virtually tick for tick, because brokers are obliged to match corresponding CFD positions with live positions in the underlying asset market, as a hedge against risk and a value-added service to traders. This can make it far easier to follow how the pricing is laid out, and with the exception of certain ‘market makers’, who as brokers have responsibility to set their own spreads and price points, this presents a much more transparent and clear representation of price.

Another immediate advantage of contracts for difference is that they are available to be traded on a considerably wider range of bases than options – including indices, exchange rates, bonds, etc. Options can only be traded on the basis that there is some underlying asset, and so cannot be traded in conjunction with any index or rate, tying the investor’s hands as far as options are concerned. Depending on which bases you are looking to trade this may or may not pose a problem, but for new traders looking for as much flexibility as possible, contracts for difference do seem better equipped to fulfill that role.