What are the pros and cons of spread betting and CFD's?

[John Naronha]

[Ignatius Bose]

Unlike exchange-traded securities, both Spread Betting and Contracts for difference (CFD) are traded over the counter. A CFD is a bilateral derivatives contract where the buyer agrees to pay the seller if the price of the security drops and the seller agrees to compensate the buyer in the event of the price of the security rising. Spread betting likewise is a derivatives product with traders betting on a range of potential results in the price of the underlying security.

Before getting into the pros and cons of the OTC traded products, a quick look at the key features of the two products

CFD’s-

• A platform where speculators bet on the price movements of financial securities such as equities, commodities, currencies, indices and fixed income instruments.
• Traders do not own or intend to possess the underlying asset; instead, they speculate in lots or contract size depending on the market insight.
• CFD’s are highly leveraged products and traders who bet on these instruments will either magnify their profits or losses correspondingly.
• Margins are variable and could be anywhere between 5-20 percent of the contract size.
• Traders have the option to place stop loss orders.
• CFD brokers offer trading advice/ buy-sell recommendations.
• Since CFD’s were introduced as day trading products, overnight positions incur “holding costs,” which can be positive or negative depending on the outlook of the trade, the underlying security, borrowing costs, etc.
• Traders with overnight long positions are generally charged holding costs, while those with short positions receive interest for stocking overnight positions.

Spread betting-

• Spread betting involves wagering on a specific price move in a security in either direction by placing a currency value on the minimum price movement.

          Ex: Betting on a 10-pip upside in the EURUSD where 1-pip= $100.

• Spread betting providers are execution only since traders are directly betting against them.
• Contracts have expiry dates but can be rolled over by paying a small fee.
• Traders have the option to place stop loss orders.
• When a trader is involved in spread betting, the price bets are generally against the broker or the company providing the facility.
• The difference in the buy-sell spreads on the trading terminal is entirely left to the discretion of the broker.
• Brokers providing the facility not only earn from the bid-ask spread but also profit when traders make losses.
• Spread betting can be closely linked with gambling since there is always one winner and one loser in every transaction, which may not always be the case with CFD’s.

Coming to the pros and cons

CFD’s-

• 24-5 dealing desk.
• Leveraged trading.
• Direct market access to a large number of asset classes.
• Market makers quote prices but traders can place quotes within the bid-ask spread.
• Bid-ask spreads could be high, but the markets are generally more liquid when compared to spread betting.
• Counterparty risk and conflict of interest exists, but it is lower than spread betting since CFD brokers generally hedge their risk.
• The minimum contract size is generally large, most appropriate for skilled traders.
• The impact cost is higher than the exchange-traded markets due to the relative difference in the bid-ask spreads.
• Positions are generally denominated in the currency of the underlying asset which can lead to FX risks.
• Commissions are charged separately and are usually a small percentage of the deal value.
• Holding costs on overnight positions is a definite negative.
• No stamp duty.
• CFD’s are subject to capital gains tax, but losses can be offset against taxable income.

Spread betting-

• 24-5 dealing desk.
• Leveraged trading.
• Prices are quoted by market makers and may not characterize the market price of the underlying security traded on the exchange.
• No commissions.
• Variable contract sizes, a plus for beginners and small traders.
• No FX risk since profits/losses are generally in the currency of the country from where the broker operates rather than in the currency of the underlying asset.
• Low liquidity and counterparty risk.
• The impact cost is mostly higher than CFD’s since the bid-ask spread is at the discretion of the provider.
• Expensive to day trade.
• Comprises of rollover costs.
• No stamp duty.
• Profits are tax-free, but losses cannot be offset against taxable income.

Both the products have their own set of pros and cons. While CFD’s may be the preferred choice of hedge funds and larger players, spread betting could be more suitable for the less experienced trader looking to place smaller bets.