By far and away the biggest change for private investors over the last decade has been the proliferation of two types of trading account: contracts for difference (CFDs) and spread betting accounts.
These have radically changed the way you can trade – you can save yourself a bundle if you use each selectively.
The trouble is that many investors don’t really know the difference between the two.
That’s what I want to look at today. I’m not covering how these accounts work – for an excellent starter on that you should look at MoneyWeek’s introduction to online trading
What I want to look at today is which of the two accounts is more appropriate for you. Because when you look under the bonnet there are some important differences.
The way I see it, there are four key considerations to take into account when deciding where to place your trade…
1. Tax
Neither spread bets nor CFDs attract stamp duty. Okay, that’s only 0.5%, but it’s worth having.
More importantly, spread bets don’t attract capital gains tax (CGT), so if you tend to cash in profits over £10,100 a year, then it’s very likely that a spread bet is better for you.
2. Execution costs
Execution costs are often misunderstood. Many investors think that this is simply your broker commission. But that’s only the start of it.
As well as paying your broker, you have to pay the market bid/offer spread. These are the prices dictated by the market makers. Just like when you buy currency for your holiday, there’s a different price whether you’re buying, or selling. And the less liquid a stock, the bigger the spread.
This is where you’ll start to see the benefits of having a good broker. Any broker worth his salt will phone around the market makers and get you a decent price. You need to ask for a price ‘inside the market’.
So say a stock is quoted 50-55 – they’ll buy the shares from you at 50p and sell to you at 55p. The idea is to get a price inside the spread. Tell your broker you won’t pay anything more than 54p (or you want 51p for a sale).
This is very important. You can easily end up paying 10% on the spread. So choose your stockbroker carefully – and that goes for spread betting and CFD providers too.
When it comes to getting a price ‘inside the market spread’, a CFD can often be better than a spread bet. Many CFD providers will allow you to place your own order inside the spread. A spread bet, on the other hand is a ‘take it or leave it’ price.
But then again, spread bets don’t have any commission. Therefore, so long as the spread is tight, you’ll be okay with spread betting. CFDs generally do charge a commission between 0.1% and 0.2%. But if you’re dealing in a stock with a sizeable spread it’s well worth paying the commission if it gets you a good price.
And beware the spread bet as you could end up paying this spread many times over…
3. Finance charges
With a spread bet you can currently buy a June contract on a stock. But if you want to keep your position open after that, you’ll have to buy the September contract.
This is called ‘rolling over’ the bet. And usually you’ll be charged around half the spread again for your rollover. Now even if your stock has a spread of 2%, you’ll have to pay 1% every quarter. That’s 4% a year!
And on top of that, the spread also includes an implied cost of carry – that’s basically the cost of interest on your margined position. Say you’re holding £50k of BT shares with just £5k down as a deposit, you don’t expect your provider to finance the £45k cost of carry for free do you? They’re too smart for that. So they roll the cost of carry into the spread quote.
The point is that with a spread bet you can end up paying twice to finance a long-term holding. Once in the spread and then again in the rollover.
That’s where CFDs offer a distinct advantage. The cost of financing the contract is totally separate from your spread – and there are no rollovers…
Unlike the bet, a CFD contract has no end date. It’s just like owning a ‘real’ stock. Of course the provider has to charge you a cost for financing the position – again you don’t get owt for nowt…
Most providers charge something like 2% over base. So with the base rate at 0.5%, that’s 2.5% a year.
Where else can a private individual borrow at that rate? I like the fact that this charge is low and it’s transparent. That’s why I’d always use a CFD for long term trades. I know what the charge will be at the outset – and it’s very reasonable at that.
4. Currency issues
There’s a major difference between a spread bet and CFD when it comes to currency. And depending on how you want to play currency, you need to pick the right one.
spread bets are quoted in sterling and CFDs are quoted in local currency. For my gold spread bets this has worked out great. As the dollar weakened, gold has been going up. I’ve been delighted to have my winnings paid out in sterling – a hedge against the falling dollar.
But often you want to play the currency game the other way round – i.e if you think sterling is going to weaken against your trade.
I’ve been urging readers to get some exposure to countries and currencies other than the terrible trio (£, $ and €). So maybe you want to trade Swedish stocks with exposure to its krona.
Here’s where a CFD comes in handy. You buy the Sweden 30 contract denominated in krona – so if the krona strengthens against the pound you’ll benefit from the uplift. On top of that, you’ll get whatever the index is doing plus dividends.
Go with the account that suits the trade
Both spread bets and CFDs offer major benefits to users. Likelihood is you should have both. The key issues of currency exposure, how long you want to hold your position and the liquidity of the stock will determine what sort of account is best for each trade.
Personally, I use CFDs for long term trades. And I like to keep some money aside to play any short term opportunities I spot with my spread betting account – I have a few more ideas brewing that I’ll let you know about shortly.
And let’s not forget tax. If you’re lucky enough to regularly hit the CGT threshold you should definitely consider a spread betting account.
If you want to, you can check out the spread betting and contracts for difference.
Finally, let me just also say that trading through a spreadbetting or CFD account is always a risky venture. You can win big. But you can also expect a great deal of volatility. And there is a serious chance that you will lose more than your initial stake. So please don’t put down more than you can afford to lose.
Important Information
Spread betting carries a high level of risk to your capital. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Margin amounts vary between spread betting companies and the type of markets spread bet. Commissions, fees and other charges can reduce returns from investments. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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