Nick Sudbury outlines the advantages of using contracts for difference and spread betting compared with traditional share dealing.

In the past few years there has been a dramatic increase in the number of private investors using spread bets and contracts for differences (CFDs). Most tend to find the transition from a normal share dealing account pretty straightforward, which has allowed these instruments to become more of a mainstream option than they ever were previously. In fact, industry insiders estimate that the combined UK client base has grown to around 325,000 people.

Spread betting is the more popular of the two as any profits are tax free, though highly active traders and those who deal in large quantities often prefer the greater transparency of CFDs. Other than that, they are both very similar, with each providing exposure to price movements rather than the legal ownership of the underlying assets.

‘The beauty of these instruments is the flexibility and control,’ says James Hughes, market analyst at CMC Markets, ‘as they allow people to get in and out of the market whenever they want.’

Another big plus is that investors don’t have to finance the full purchase price themselves. For example, when buying a large blue-chip stock like Vodafone, they would typically only need to have around 5 or 10 per cent of the cash in their account. This is known as ‘trading on margin’, with the rest of the money effectively borrowed from the broker.
Buying the equivalent of £5,000 worth of Vodafone shares would only initially require around £250 to £500 of capital.

This margin deposit represents the realistic level of cash needed to maintain the exposure, although the rate is considerably higher for more volatile securities like the mid- and small-caps.

Enhanced returns
Spread bets and CFDs tie up less cash than the equivalent share purchase, yet the investor is still exposed to the same absolute profit and loss. This leverage has the effect of magnifying the potential gain, since a 5 per cent rise in the price would be equivalent to a 50 per cent return on the committed capital, assuming a margin requirement of 10 per cent.

What this means in practice is that relatively small share price movements of 5 or 10 per cent can be quite profitable, which gives investors more scope to make money. The downside is that the enhanced sensitivity demands a proactive approach, as it is imperative to cap losses early rather than run the risk of allowing them to escalate out of control.

‘Because of the leverage, a small price movement in the investor’s favour can result in a high return on the money placed on deposit,’ explains Rick Girling, head of business development and marketing at Halifax Share Dealing.

‘The opposite is also true in that a small price movement against them can produce substantial losses, which may potentially exceed the funds in their account.’

Controlling the risks
In order to prevent running up large unsustainable losses, investors need to have a disciplined system of risk management.

This means planning each trade in advance with target entry and exit levels. It is also important that people don’t open too large a position relative to their capital and always have a stop-loss in place.

Stop-losses are a type of order that can be left in the market to automatically close an exposure should the price move unfavourably by a certain amount. If they are triggered, the trade would then take place at the next available price, which means there is a risk of slippage on the exit level. Those who are uncomfortable with this may be able to opt for the added security of a guaranteed stop.

‘With a guaranteed stop, the order is executed at exactly the price specified,’ adds Girling. ‘There is a premium payable for this service, but it provides the peace of mind of knowing the maximum possible loss regardless of what happens in the market.’

Wide range of markets
Most spread betting and CFD accounts allow people to trade anything from UK and overseas shares to stock market indices, currencies, commodities and bonds. Some of these areas would otherwise be pretty difficult for private investors to access. The spread bets are particularly convenient as they are all denominated in sterling, so there is no need to worry about any currency complications.

Those interested in company shares will generally be able to trade the price movements of the major UK, US, European and Asian equities. Some providers also quote the small-caps, although the coverage varies from firm to firm and market to market.

‘Our CFD and spread betting customers can trade UK and international shares, indices, currencies, commodities and UK sectors. They can even go long or short on ETFs [exchange-traded funds], if they wish,’ says James Daly from the TD Waterhouse Investor Centre. ‘Small stocks with less than a £50 million market cap are not covered, but these are less likely to be suitable for the sort of short-term trades normally associated with derivatives.’

The most popular areas tend to be the currencies and indices. These provide a top-down view of the market as a whole and diversify much of the stock-specific risk. They are also cheap to trade and available round the clock from Monday morning to Friday evening.

Shorting
Spread bets and CFDs provide an easy way for people to sell short so as to profit from falling prices. The investor is in effect able to mimic the act of selling shares that he does not own. If the price then falls, the position can be closed at a profit by buying them back at the lower price. This may sound completely counter-intuitive, but in reality it is simply the opposite of buying a position that is expected to rise in value.

David Jones, chief market strategist at IG Index, says that in the past year and a half it has been critical to be able to sell short: ‘There are still plenty of weak stocks that would make good shorting opportunities. The easiest way to spot them is to look for shares that are in a downtrend or for those that have just hit a 52-week low.’

Some of these situations can produce huge profits in a matter of hours. The prime example was Northern Rock, which last year became the most heavily shorted stock in history after it was announced on the BBC evening news that the bank was in trouble. This heralded a collapse in the share price and massive gains for those who had gone short.

Cost effective
Most providers take their prices direct from the underlying stock exchange. With a spread bet, they will then typically add a fixed mark-up to the bid-offer spread, whereas with a CFD they will levy a separate charge for commission, which might be as low as 0.1 per cent on each leg of the transaction. There is not normally any form of account management fee.

CFDs and spread bets are exempt from the 0.5 per cent stamp duty charged on UK share purchases, so short- and medium-term investments may actually work out cheaper than buying the underlying stock. Longer-term positions will be more expensive as the financing cost of trading on margin, which is normally deducted from the account each night, will eventually exceed the stamp duty.

‘We charge LIBOR plus 2.5 per cent on long positions. Therefore, assuming an overnight rate of 0.55 per cent, our charge would equate to 3.05 per cent per annum. In this scenario, it would take 60 calendar days for the accumulated financing charge to exceed the stamp duty saving,’ concludes Daly.