An investor’s guide to using spread bets and CFDs to enhance portfolio returns
From hedging, to increasing market exposure, there are multiple ways in which an investor can benefit using spread-bets and CFDs.
Introduction
Falling costs and wider market access have made investing much more accessible to UK retail investors. However there are many investment strategies that are only accessible to investors through CFD and spread betting platforms, whose services are more familiar to traders.
Indeed many investors use CFDs and spread bets without using much, if any, leverage at all.
In this guide we outline the attractions of CFDs and spread bets, explain how clients of Private Banks are able to leverage their portfolios and give examples of the many ways in which UK investors are able to use CFDs and spread bets to make both short term tactical and long term strategic investments.
What are CFDs and spread bets?
Conventional share dealing allows an investor to buy and sell shares and ETFs across a variety of markets, paying a commission to do so. CFDs and spread bets are similar, but instead of owning the physical stock you have a simple derivative exposure with the platform provider.
CFD’s and spread bets are interesting for investors as they give the flexibility to go short and also to use leverage which can magnify gains and losses. Spread bets are tax free, similar to making investments in an ISA, while CFD’s are taxable which makes them popular amongst investors who want to hedge existing positions. Both products are exempt from stamp duty which is charged at 0.5% on UK shares.
Share dealing platforms make money from dealing commissions, fx commissions and custody charges. Spread betting platforms don’t charge commissions and instead make money from the bid-ask spread and overnight financing charges which are typically 3m Libor + 2.5%, an amount which is very competitive against other sources of finance.
When you go long a stock in a CFD or spread bet, IG is automatically short and in 99% of cases will go into the market to hedge the exposure. This aligns IG with its clients.
Advantages of spread betting
- No capital gains tax*
- No commission, just our spread
- Easy to bet in the currency of your choice -greater control of currency exposure
- Deal on rising and falling markets
- Leveraged access to the markets
- No stamp duty
- 24-hour dealing
- Use prices based on the underlying market
* Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
Advantages of CFDs
- Direct market access (DMA) on forex and shares
- Trade at the market price on shares
- Losses can be offset against profits for tax purposes
- Deal on rising and falling markets
- Leveraged access to the markets
- No stamp duty
- Use prices based on he underlying market
Contrary to popular belief, opening a CFD or spread bet does not mean that you have to use leverage. When you take a position in a particular stock or market your leverage is determined by your contract size and the amount of cash you hold in your account. For example a client with £10,000 in cash who is short the FTSE 100 at £1 a point would have an exposure of £7,500 if the FTSE was at 7,500 points. Similarly opening a position at £0.5 a point would have an exposure of £3,750.
Did you know that the majority of investors already use leverage?
Many people have a mortgage while having separate investments in shares and ETFs through ISAs, SIPPs and general investment accounts. If you fit into this profile, whether you realise it or not, you are already an investor that uses borrowing to try and enhance your investment returns. To calculate the amount of leverage you use, simply divide the value of your outstanding loans by the value of your assets.
Example:
Rod has a property worth £400,000, a mortgage of £300,000 and an ISA worth £50,000. He has total equity of £150,000 which is made up of £100,000 equity in the property, plus his £50,000 ISA. Dividing the debt of £300,000 by the assets makes his household balance sheet 2x leveraged. If his equity in the property was only £40,000 – holding a 90% mortgage – his household would be 4x leveraged which is calculated by dividing the £360,000 mortgage by £90,000 of assets.
With the majority of investors using some leverage at any one time, it makes sense to ask yourself how much you are comfortable using?
Whether it is using leverage to buy property, a car, art or shares, selecting your desired level of borrowing is unique to every individual and is a matter of both risk tolerance and your expectations of future earnings.
In the long run you are very likely to be required to pay off your mortgage as banks have age-based lending restrictions, but if your financial position is sufficiently comfortable and your investing personality tolerant of taking additional risk there is nothing to stop you using long term borrowing to try and improve investment returns over time.
While spread betting providers offer clients the ability to borrow substantial amounts (up to 20:1 for a major equity index), you are not required to use that. You might have £5,000 in your spread betting account but hold just one position with a £5,000 notional value – effectively your leverage here is zero.
Whether you own a business, have other illiquid assets, or simply want to try and enhance your returns, CFD’s and spread bets can be an attractive way to get additional exposure to an investment or asset class without incurring borrowing costs through conventional bank-based mortgages or personal loans. There are no set-up costs and the amount of leverage that you use can be varied on a daily basis without having a fixed loan amount, which could save on fees in the long run.
Think of leverage as being a loan
When you envisage who the average client of a Private Bank could be, you might assume that they are middle aged, wealthy and risk averse – focused on preserving their wealth for future generations rather than actively growing it. While this is true for some, one of the services that Private Banks offer is lending to clients that seemingly have no requirement to hold any debt. These loans can be secured against the value of a property (a mortgage) or frequently against the value of a managed investment portfolio. This arrangement is known as a ‘Lombard Loan’ and may occur because a client is unwilling to pay tax on crystallised capital gains or simply that they are comfortable with using leverage to increase prospective returns.
Firms that offer spread betting and CFD trading can effectively give the same service to clients, but instead of using stocks and shares they use cash as margin for open positions. New European rules have lowered leverage limits for retail clients, with allowable exposure ranging from 5:1 for equities to 30:1 on major currency pairs, but in reality a long term investor need not use nearly so much. 10% to 20% leverage on an equity portfolio should be enough to enhance long term returns while minimising the chance of a margin call.
Remember: investing uses a different skill-set to trading
Using leverage as an investor is very different to using leverage as a trader and requires a different perspective. Traders often take very short-term views, opening and closing positions several times a day, and usually need to use higher amounts of short-term borrowing to generate their returns. Trading requires rigorous monitoring of markets, tight risk management in using stop losses and never risking more than a small amount of your trading capital on any one position. Traders typically use a series of charting tools which most investors will be unfamiliar with, such as candlestick charts, Bollinger bands and Fibonacci retracements.
Trading regularly effectively offers a binary outcome: you are either a winner or a loser on each individual trade, thus for each person that goes long GBP/USD there must also be someone that takes the other side of the trade. In the long run, those with skill should outperform the rest of the market.
Leveraged investing, on the other hand, can employ a rather different approach. As long as the return on your asset class is higher than the cost of your financing, you should be able to profit from using borrowing to enhance equity returns or generate a higher income from yield-generating assets.
Returning to the example of a buy-to-let investor, profits are generated from capital growth of the underlying asset and income from the property. If there is no capital growth in the asset, the income must be greater than the mortgage interest rate to avoid a loss.
Leveraged investors can theoretically hold one position – such as an equity index – for many years without selling it. Yet to do this successfully, the number one rule of using leverage is that you mustn’t use too much. Investors should always be prepared to lose money in the short term; potentially seeing a portfolio of assets fall -40% in a crisis such as 2008/09. As a rule, the more volatile the asset class is, the less leverage you should use in a long-term strategy.
Example:
Between 2007 and 2017 the MSCI World global index has had seven declines of more than 10%, the largest being -38%. A long-term investor using less than 2x leverage would have had time for their portfolio to recover, but any more and they may have been forced to provide money for a margin call.
An investor in UK Gilts has had a rather smoother experience; the index has only fallen in value by 5% or more on five occasions, with a maximum drawdown of -8.3% in 2016 after equity markets recovered after the Brexit result.
Due to the relative volatility of the asset classes, an investor could use more leverage to go long or short gilts than they would deploy in equities.
While excessive leverage can cause the downfall of the long-term investor, time is your friend as it allows your positions to recover for as long as your fundamental view is correct. There’s no need to trade often either, investors can hold positions for years.
This is where a platform that offers users the flexibility to set up separate sub-accounts across the different market access routes has an edge – it makes it easy to differentiate between your trading-focused positions and your longer-term investment allocations.
Using a bit of leverage to go long is just one type of approach an investor could take. Now let’s find out what other techniques you can deploy to profit from CFDs and spread bets in the way an investor would.
How investors use CFDs and spread bets
Investors can use CFDs and Spread Bets for a variety of reasons, taking both short term tactical views and long-term strategic views to complement their existing share portfolios.
These trades fall under several different types of strategy:
- Hedging a portfolio or individual exposures
- Increasing market exposures to profit from either long-term asset class returns or short-term gains after sell-offs
- Relative value trades, such as pair trading
- Accessing markets that are unavailable in share dealing
- Short term allocations for tax purposes
In the following pages we outline some of the scenarios in which investors may look to make these types of trades.
Hedging:
- Hedge another investment’s currency risk
- Temporarily reduce the risk in a portfolio
Hedge a foreign currency risk
CFDs offer an easy way for foreign property owners and buyers to lock in the prevailing exchange rate, or to hedge away a proportion of their exchange rate risk. In this example we outline the thought process a property seller could use, but it could just as easily be someone hedging their USD currency gains in an investment account after the Brexit referendum result.
Example:
Sarah owns a small apartment in Spain, which she has agreed to sell for a price of EUR 150,000. However the conveyancing process is taking longer than expected.
Sterling has been very weak recently, falling from GBP/EUR 1.50 to GBP/EUR 1.15, increasing the value of the apartment from £100,000 to £130,400. Sarah would like to lock in that foreign exchange gain which she would lose if the pound recovers against the Euro.
Sarah will have to pay tax on the sale of the apartment and therefore wants to be able to offset any further FX gains on the apartment with possible losses on the currency hedge. To do this she uses a CFD, buying 11.4 contracts which gives her a notional exposure to GBP/EUR of £131,100.
Three weeks later contracts are exchanged, following which she receives EUR 150,000 and closes the CFD position. The GBP/EUR FX rate has moved to 1.17 giving her a profit on the CFD which offsets her £2,200 loss on the exchange rate.
Temporarily reduce the risk in a portfolio
At times markets can run away with themselves, leading to short term gains which might be followed by a reversal in sentiment and a loss later on. An investor with a particular financial goal might be unwilling to take on downside risk in their investments but doesn’t want to go to the expense and hassle of selling large amounts of their portfolio.
Hedging can be designed to mirror your investment portfolio, so that if the market declines your hedge performs more or less in the opposite manner.
Example:
Caroline has £150,000 in her ISA and is looking to reduce her risk without selling and re-buying numerous positions, some of which are in foreign currencies and therefore costlier to trade. Markets have performed very strongly recently and she decides to hedge away half of her global market exposure on a temporary basis.
She opens a short spread bet on iShares Core MSCI World (SWDA), which is priced at 4,166.7, at £18 a point, giving her notional exposure of £75,000.
Ignoring financing costs and market spreads, if the market falls -10%, Caroline should lose £15,000 on her ISA and make £7,500 on her spread bet, a total loss of £-7,500. If on the other hand the market rises 10% she will have made £15,000 in her ISA and lost £7,500 on the spread bet, gaining £7,500 overall.
Increase market exposure:
- Gear up a high yielding asset class to increase the yield further
- Modestly increase long-term exposure to the stock market
Use leverage to enhance an income
Buy-to-let investors often follow an investment strategy whereby they purchase a property with a higher rental yield than their mortgage costs. If there is no capital appreciation the yield should pay off the mortgage over time.
Investors are able to use a similar approach on CFD and spread betting platforms, such as the one outlined here.
Example:
James has £10,000 in cash and is looking to buy some high yield bonds which have fallen in value during the recent sell-off and now offer an attractive yield of 6%. He knows that high yield bonds are less risky than equities and is comfortable with a buy and hold strategy while using some leverage to enhance his returns. He has already used up his ISA allocation and is a higher rate taxpayer, so he decides to open a tax-free spread bet in the iShares $ High Yield Corporate Bond ETF (SHYU).
James knows that as long as he 1) doesn’t use excessive leverage and is forced to close the position, and 2) the bond’s yield is higher than his financing cost, he should be able to make money in the long run.
James goes long SHYU which has a bid-ask spread on the platform of 7468 – 7500 (0.43%), slightly wider than the live London Stock Exchange bid-ask spread of 0.33%.
At £1 a point his economic exposure would be £7,500, so he decides to open the position at £4 a point giving him £30,000 of notional exposure. The margin required is £6,000 which is comfortably covered by his cash in the account.
Ideally James would like to make a short-term gain on the high yield bonds, but he knows that SHYU has a yield to maturity of 6.0% which (before all costs) could theoretically make him 18% a year tax-free. He is therefore happy to hold the position for some time if necessary.
James buys the cash contract which has an overnight funding charge of 3m Libor +2.5%, an annualised cost of 3% as 3m Libor is at 0.5%.
Six months later, SHYU has made a total return of 6% (3% from dividends and 3% from share price appreciation). He closes the position having received cash credits from dividends of £900 while making £900 from share price appreciation. His costs are £129 on spread and £450 in financing, a total return of £1,221.
If James had bought SHYU on IG’s share dealing platform he would have received £300 in dividends and £300 from share price appreciation, while paying £16 in dealing commissions and £32 in spread, a total return of £550. He would then have to pay tax on the income.
Over the six months James has made 12.2% on his £10,000 investment as opposed to 5.5% if he had bought £10,000 of SHYU on a share dealing platform.
Modestly increase long term exposure to the stock market
A common tactic of Investment Trusts, a type of listed fund that is listed on a stock exchange, is to use modest amounts of leverage – typically less than 20% - to try and outperform their benchmarks. The leverage increases gains in rising markets, but equally when the market falls, they will have larger losses.
Investment Trusts use a variety of borrowing techniques to leverage their portfolios such as issuing preference shares, bonds and convertible bonds alongside conventional bank borrowing. The disadvantage of this approach is that the additional borrowing must be paid for, whether it is used or not. CFD and spread betting clients do not face this hurdle, being able to be much more flexible with the amount of overnight borrowing they use.
Example:
Michael already has £50,000 in his share dealing account, diversified across several positions and investing for the long term. However, he is confident in his outlook for the economy and decides to gear his portfolio by 20%.
Michael is confident that he can hold his position for long enough to ride out short term volatility and therefore he chooses a tax-free spread bet. He wants to get £10,000 of notional exposure on the FTSE 100, which – with the FTSE 100 at 7,000 points – is a bet size of 1.4 pounds per point.
His long-term financing cost is 3m Libor + 2.5% on a cash contract (which he could lower by using futures), so as long as the FTSE 100 returns more than that on a total return basis he should be profitable.
Relative value trades:
- Open a market-neutral pairs trade
- Get exposure to an asset without taking any currency risk
- Open a position in a market that is unavailable on a share dealing platform
Pair trading
Pair trading is a very common strategy in the investments world and is designed to profit from going long one security and short another, profiting if the long position performs better than the short.
Even if both investments fall in value, as long as the long has fallen by less than the short the investor can still make money. Typically, investors will want to use this strategy with two investments which are quite closely correlated to each other. This could be two companies in the same sector, a pair of indices or even buying an Investment Trust on a discount and shorting the underlying benchmark.
In the example below we outline how someone expecting markets to fall could place a trade.
Example:
With Brexit clouds on the horizon, Amit is concerned about the outlook for the UK economy. He forecasts that the UK will fail to get a good trade deal from the EU which will cause the domestically focused economy to suffer.
To attempt to profit from this theory Amit decides to go long the FTSE 100, which gets a lot of revenue from overseas, and short the FTSE 250 which has more of a domestic exposure. He has £5,000 in cash and wants to try and make a 20% return on this; a profit of £1,000.
Amit studies the markets and forecasts that the FTSE 250 could underperform by 10% over the next year. Therefore, to get his return he needs to have at least £10,000 of exposure in the pair trade.
He’s confident he will be right and opts to use a spread bet to make a tax-free gain, rather than a CFD where he could offset losses against gains elsewhere. Amit goes long the FTSE 100 at £1.4 a point with the FTSE 100 at 7,500, a notional exposure of £10,000. He hedges that with a short position in the FTSE 250 at £0.5 a point (the FTSE 250 is trading at 20,000 points).
Unfortunately for him three months later Theresa May comes back from Brussels having secured a deal of sorts and the FTSE 250 goes on to outperform the FTSE 100 by 5%. Amit closes his positions having made a loss of £500 alongside paying around £38 in financing costs.
This approach can also be used to trade equities, often attempting to partially hedge away the regulatory or political risk that you might face with a 100% long position in a stock.
Example:
Julian has a very positive view on the housebuilder Redrow, which trades on a low P/E multiple relative to the rest of the sector. He thinks housebuilders have a rosy outlook but is wary of the UK Government ending state support through ‘Help to Buy’, so he decides to partially hedge himself.
Julian has £100,000 in his shares portfolio across a number of ETFs and shares and doesn’t want to sell any of his positions. Nevertheless, he wishes to get a decent exposure to Redrow to express his conviction view. Julian decides to go long £10,000 of Redrow, hedging it with a £5,000 short on Persimmon, increasing the net exposure of his portfolio to 105%.
He decides to use a CFD in case he is wrong, which will allow him to offset any losses against his other gains. Julian goes long 1,667 shares of Redrow (1,667x 600p = £10,002) and short 176 shares of Persimmon (176 x £28.40 = £4,998). He pays £16 in commissions and avoids paying £50 in stamp duty on the long Redrow leg.
Get exposure to an asset without taking any currency risk
When an investor buys a foreign company, they immediately take on currency risk in that asset. Currency pairs can be quite volatile, which can make a large impact on your total return which we see in the example below.
Example:
Rachael would like to purchase approximately £10,000 of Apple in her ISA, but on the buy and sell legs faces commissions of £15 as well as FX fees of 1% each way; a total round-trip cost of £230. Rachael also doesn’t want to take on any FX risk as she is concerned that the USD may decline in value against GBP hurting her total return.
Instead Rachael opts to open a spread bet. The minimum contract size with the broker is £0.5 a point, and the contract value is 18,900. This would give notional exposure of £9,450. Rachael decides this is close enough to what she wants and has more than enough money to cover the initial margin of £1,890.
Six months later she has paid financing costs of around £150, but Apple has gone up by 10% (including dividends), and she was right about the currency too – Sterling has gained 10% against the USD which would have eroded all of her return had she bought the holding in the ISA.
The spread bet has successfully hedged away her currency risk.
Open a position in a market that is unavailable on a share dealing platform
Leveraged trading platforms often offer a much more advanced range of markets than you can access through a share dealing platform. If you have ever wanted to get exposure to individual commodities or shares on less popular international exchanges, such as Hong Kong and Singapore then a trading platform could prove to be an easier access route.
Example:
Rhys works as an economist and has been monitoring the recent Italian elections. He thinks it very unlikely that Italy will leave the Eurozone and sees an opportunity to buy Italian Government debt when the yields sharply increase.
He is unable to find a suitable instrument to buy in his share dealing account, but he notes that he can go long an Italian BTP future via a spread bet. At a contract size of 13,000 Rhys goes long at £3 a point, a notional exposure of £39,000, aiming to make a quick 3% return after costs which could net him £1,170.
He is uncertain about the short term direction of the trade so deposits £5,000 into the spread bet account to allow for some volatility and possible paper losses in the coming weeks.
Short term allocations for tax purposes
With gains from spread bets being tax free they can be used as short term solutions to manage tax bills. In the 2018/19 tax year dividends above £2,000 are taxed at 32.5% and 38.1% for higher and additional rate tax payers, which can cause a significant drag on the total return an investor makes on high yielding shares.
Example:
Raj is retired and has an investment portfolio worth £200,000 alongside other income sources. He is a 40% marginal tax payer and has a £40,000 holding in Vodafone which currently yields 7% and pays a dividend twice a year. The final dividend for the 2018/19 financial year is 4.5% which would make him £1,800 but will be reduced to £1,215 after tax.
The day before the share goes ex-dividend Raj sells the stock (paying an £8 commission) and switches his exposure into a spread bet. On the day the share goes ex-dividend, the share price drops to account for the dividend and Raj receives a dividend credit which is added to his cash position.
The next day Raj closes the spread bet and re-purchases Vodafone in his share dealing account paying another £8 commission and £200 in stamp duty. After all commissions and financing have been taken into account, he is up by £360.
Conclusion
Spread bets and CFDs are the number one tool of choice for active traders, but as we have seen they can also be used in a number of ways to give clients access to the strategies that professional investors deploy to manage their portfolios and get an investment edge.
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