TheRateTart Spread Betting and CFD Guide
Contents
- Introduction
- How a Spread Bet or Contract for Difference (CFD) works
- The Benefits and Risks
- How Spread Betting & CFD Companies Make Money
Spread Betting or Contract For Difference (CFD) accounts are a recent development for UK private investors. Both spread betting and contracts for difference are complex investment vehicles and definitely should not be considered by inexperienced investors. If you are new to direct investment in the stockmarket start with an online trading account and build up your knowledge and experience first.
How a Spread Bet or Contract for Difference (CFD) works
When making a spread bet or CFD, the investor is not purchasing a physical asset. Instead they are betting on a range of outcomes. For financial spread betting the outcome bet on is price movement of shares, commodities or other investment vehicle. For sports spread betting the outcome can be any one of a number of variables within that specific sports event (for example, goals scored in the first half, corners taken in the second half, free kicks awarded etc). Because of this spread bets or CFDs are short term investments, typically made over a period of days or weeks rather than years. As money is made primarily from price volatility rather than growth, profits come from other traders rather than the company or general stock market.
A basic example of a spread bet is provided below.
Spread Betting Example. Imagine that TheRateTart was listed on the stock exchange (which it isn't) and that you believed the company was seriously undervalued (which it is), but that the price would rise significantly in the near future (let's hope so). The stock is currently trading at 200p and your favourite spread betting company is offering a spread of 195p-205p on the stock. You decide to bet £10 per point on that the price will rise. This means that for every penny over 205p you will make a profit of £10.
If two months later TheRateTart shares were trading at 225p you would have made a profit of 20 points or £200 at £10 per point. You can then close your bet and pay a financing charge to the spread betting company. The outstanding profit is your net gain on the bet.
If on the other hand the market decided TheRateTart was overvalued (admittedly, unlikely) and two months later shares were trading at 160p, you would have made a loss of 25 points or £250 at £10 per point. You would also have to add the financing charge to your losses. Your overall loss would be limited by the share price hitting 0p. But assuming you do not want to be exposed to £1950 of risk plus charges, you would be better off putting a stop loss order in place to ensure there is a limit to your exposure.
The Benefits and Risks
Placing a spread bet or contract for difference is a complex investment. Not only do you have to assess the chances of a particular outcome happening, but you also have to work out when these changes will take place. However, with increased risk comes increased potential reward. The list below highlights some of the main benefits and risks of spread bets and contracts for difference;
- Bets are usually made over days or weeks. You can make higher profits over a shorter time period than could be achieved via a traditional stock market investment. Equally, you could also rapidly run up extensive losses amounting to more than your initial outlay if things don't go as you predict. Consider using a stop and limit order to put a cap on any potential losses you may incur.
- Spread betting or CFD transactions are geared. This means you the potential profits or losses from a given outlay are much greater than if you had invested in shares. However, you may have to pay a financing charge for this gearing. Remember that in the event of losses you will need to be able to pay back the full amount of your stake (i.e. how much your bet would have cost without the gearing) plus any other losses incurred.
- There are tax advantages to spread betting and contracts for difference. On both types no stamp duty is paid. This differs from share purchases where stamp duty is payable on each transaction at 0.5% of the value. For spread bets (but not contracts for difference) capital gains tax is not payable on any profits. Of course, this also means that losses cannot be offset against profits from other investments.
- As well as betting on prices going up, you can also bet on prices going down. This is known as 'shorting' and can provide an opportunity to profit from falling markets. However do not be fooled into thinking this is a no risk option. Remember, you are betting on an outcome. You have not actually bought any shares or commodoties. Therefore if the share or commodity price goes up you have lost your bet and will incur losses in the same way as if a share or commodity you actually bought had lost value.
How Spread Betting & CFD Companies Make Money
Most revenues come through the various fees and charges levied. These are split between commission and financing charges for the funds required to gear the spread bet or contract for difference.
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