The rise in online trading’s popularity led to different rules and regulations in various parts of the world. In some countries, specific trading products are forbidden (e.g., binary options in Australia), in other ones certain products are allowed, but subject to clear and concise rules.
One of the major issues for traders actively speculating on financial markets, taxes play an important role in deciding what markets to trade, and where.
The rise of CFDs (Contracts for Difference) in the last years led to stiff competition among brokerage houses. Nowadays, from a Forex account, traders have access to literally all markets in the world.
CFD trading on currencies, indices, commodities, individual shares, and even ETF’s and bonds, is possible from one single account. Obviously, it represents a leap forward when compared with the situation only a few years ago.
We can safely say that CFDs revolutionized retail trading as we know it today. For this reason, CFD products are popular in the entire world.
But in some countries (e.g., United Kingdom), CFDs have a major rival. Spread betting emerged as a serious competitor to CFD trading due to its tax-free component.
The technological advances increased the trading execution and narrowed the spreads so much that brokers offer similar conditions for the same product. For instance, one may trade the DJIA (Dow Jones Industrial) index and have a similar quotation for a CFD or spread betting.
However, some intrinsic differences between spread betting and CFD exist. Besides the tax-free component, a clear distinction offers a better understanding of the two products and allows traders to comprehend the risks taken fully.
Spread Betting – What Is It and Why U.K. Traders Prefer It
As the name suggests, spread betting allows traders to bet on financial markets without owning the underlying asset. In other words, you can sell something you don’t own.
Just like a derivative product, spread betting gives traders the chance to win if they are right on the underlying product’s move. But as the markets move faster and faster due to increasing speed in execution, losses can far exceed the initial stake.
Starting in the City in the 1970s, spread betting originated from a few brokers’ ideas of offering their clients bets by telephone on daily changes in the price of gold. Later in the 90s, spread betting moved to sports, and the rise of the Internet led to spread betting reaching financial markets.
A typical spread betting firm operating in the U.K. market offers now tens of thousands of products to spread bet on Forex, commodities, indices, cryptocurrencies, shares, spread bet on interest rates, sectors, bonds, and more.
Tax-Free Spread Betting – Myth or Reality
As mentioned earlier, the main advantage of spread betting comes from the fact that no capital gains tax is paid on profits. Because traders come to financial markets to make a profit, all of them are concerned about future taxes to pay.
However, a quick look at the disclaimer all brokerage houses are obligated to show on their website, and we see that most of the retail traders lose money spread betting. Hence, the “no taxes” advantage fades away as most traders (about 80%) lose money.
And, in some cases, capital gains must be paid. When trading for a living (that is, all your income comes from trading), spread betting is taxed just like any other activity. Hence, you won’t be taxed on your spread betting profits if you trade as a secondary job.
But then again, it means you already have a day job. This, in turn, affects your time dedicated to market analysis. Therefore, chances to make a profit decrease significantly as you simply don’t have time to make the right trading decision.
Spread Betting Characteristics
Typically spread betting is commission-free. In other words, spread betting brokers only charge a fee as the difference between the ask and bid prices they offer (spread).
Most of the time, the spread is tight. However, it isn’t fixed all the time, and it fluctuates wildly. That is especially important in the case of an essential economic release, like the NFP (Non-Farm Payrolls) or a central bank’s interest rate decision.
Another important thing to consider here is that spread betting effectively means a bet on the potential outcome of security. You, as a trader, aren’t trading the markets (i.e., no one takes a position on the market, simply the broker pays you the profit in case you win the bet). Finally, all spread bets have a fixed expiry date.
When compared with other financial products, spread betting became quite competitive. In fact, many retail traders don’t know the difference between, say, spread betting and CFD trading as the transactions are identical.
What is a CFD and Its Characteristics
As mentioned earlier, a CFD stands for the Contract for Difference. Most of today’s trading dedicated to the retail traders are based on CFDs.
Effectively, CFDs are derivative contracts. Their price is “derived” from the underlying market.
With no expiration date (except when trading futures), trading CFDs are subject to capital gains tax. However, while it seems like a disadvantage when compared with spread betting, trading CFDs allows offsetting losses against profits for tax purposes.
One of the major advantages of CFDs, when compared with other financial products, is their higher leverage. While regulation keeps changing, leverage is responsible for the increased popularity of such products.
However, increased leverage also magnifies losses, so traders need to have a balanced risk-reward approach.
CFD’s provide access to global markets. Literally, there’s no market in this world that can’t be traded via a CFD.
This offers around the clock opportunities to speculate financial markets. And, the possibility to hedge and protect the trading account using various correlated markets.
Another thing to mention here relates to short selling. In some markets, short selling isn’t allowed.
Or, the trader needs to borrow the instrument before selling it short. However, that’s not the case when trading CFDs.
How to Make a Profit When Trading CFDs
Because they act as derivative contracts, all that matters is that the difference between the entry and exit prices. When going long or buying a CFD contract, traders expect the value of the underlying product to increase.
On the other hand, a bearish attitude translates in shorting the market. Traders expect the price of the underlying security will decline.
The difference is the profit or the loss for a transaction. In the first case, the difference between the exit price (higher) and the entry (lower), is the profit.
In the second case, the difference between the entry price (higher) and exit price (lower) represents the profit.
Depending on the volume traded (number of contracts), the profit or loss has a different size in the trading account. But the outcome of a trade is the result before taxes.
At the end of a period (monthly, quarterly, or yearly), CFD traders must declare the capital gain or loss. If a gain, taxes are paid. If a loss, it can be deducted for tax purposes.
CFDs or Spread Betting – What Suits You Best
Most spread betting houses chart no commission for a bet. However, they do charge a spread on all markets and have funding adjustments, except for futures and forwards.
In the case of CFD trading, each broker has its own strategy and rules. The majority charge only a spread too. But, in some cases, especially in the case of CFDs that track stock prices, the brokers may charge a commission also. Or, just a commission, and no spreads.
In the end, these are costs for the trader. Imagine that in both cases, spread betting and CFD trading, there’s the outcome of a trade.
Next, there’s the fee spread. And, in some cases, a commission too. Finally, the taxes (if any) apply to the remaining amount. The amount after taxes is the net profit from trading.
For most brokers, the funding adjustment differs when trading spread betting or CFDs. Obviously, it is higher in the case of spread betting, because of the tax-free component, and lower in the case of CFD trading.
Another difference between the two is that typically, brokers don’t offer corporate accounts for spread betting. However, that’s not the case when trading CFDs.
What Should I Pick – Spread Betting or CFD Trading
That’s a question with different answers, depending on many variables. First, the trading style.
If you are a scalper (i.e., closing all positions intraday, looking to profit from quick market movements), you’ll prefer spread betting due to the tax-free component. And, the expiration date of the traded products doesn’t represent a problem.
A swing trader (a trader that keeps positions open from a couple of hours to a few weeks or even more), might decide for spread betting too. However, he/she needs to pay close attention to the expiration date and the risks involved with trading with a longer time horizon.
Investors most likely are better off trading CFDs. The explanation comes from the resources available to an investor.
Typically, an investor willing to keep a position open for more extended periods, rely on changes in fundamentals and macroeconomics. Most of the time, such traders are ahead of the curve, taking a position way before the market moves in their favor.
Hence, trading products with an expiration date will only increase the associated costs related to trading. Moreover, most investors are corporate, and corporate accounts use CFDs instead of spread betting.
Besides the trading style, taxes play a crucial role in deciding between spread betting and CFD trading. While many spread betting traders in the U.K. do not pay taxes nor duty stamp, some do pay.
For instance, traders that spread bet for a living, owe taxes. If, on the other hand, spread betting is a secondary source of income, no taxes are due. That is if traders make a profit, net of additional expenses in the trading account.
So, when trading for a living, CFDs suit best. A trader’s journey is not always profitable.
Trading goes as life goes, with ups and downs, with good and bad periods. What matters, in the end, is to be profitable over a predefined period, but profitability isn’t possible every month.
For this reason, CFD trading suits best for traders that want to offset losses against profits as a tax deduction.
Conclusion
Spread betting, and CFD trading are very similar. In fact, looking at two different trading accounts, one offering spread betting and the other one CFD trading, it is challenging to tell which does what.
For this reason, the decision to spread bet or trade CFD typically comes later in the trading process. At the start, drawn by aggressive advertising, retail traders end up opening a trading account without knowing the main differences between the two.
After a while, providing they make a profit, traders begin to investigate more about the related taxes and other adjacent costs to trading. However, with most retail traders failing to make a profit, they end up not knowing the advantages and disadvantages of spread betting and CFD trading.
To sum up, short-term speculators that do not trade for a living use spread betting. With the hope of making a profit and not having to deal with taxes nor stamp duty, they keep trying to beat the market, mostly as a hobby. Chances favor that they don’t succeed in the long run.
However, medium to long term investors chooses CFD trading. While more expensive in terms of the costs involved and taxes due, overall, the advantages of trading CFDs offset the benefits of using spread betting.
In the end, it is up to each trader to find out what suits his/her trading style best. Because all traders approach financial markets intending to generate an extra income, the first thing to come to mind is the tax-free optionality of spread betting.
But the more mature the trader becomes, the more the balance shifts to CFD trading. With regulation changing so often, look at the current conditions to change often, so traders must remain up to date all the time.
Hopefully, you have enjoyed today’s article. Thanks for reading!
Have a fantastic day!
Nisha Patel
Live from the Platinum Trading Floor.