Many people invest into equities and consider them to be good medium-long term assets to hold in their portfolio. The majority of these investors use stock brokers when speculating, unaware that there are in fact a number of feature packed alternatives available to them.
This article has been written to highlight some of the more popular alternatives to stock dealing and the benefits they hold. We will be looking at: CFD trading, spread betting and options trading.
A Contract For Difference (or CFD) is a contract between two parties that states that one will pay the other the difference in the opening and closing price of an underlying asset. In our case one party will be the private investor and the other will be the CFD broker. A CFD is a derivative meaning its price is derived from that of an underlying asset. If the price goes up, the seller will be indebted to the buyer, while if the price goes down, the opposite would apply.
People use CFDs rather than purchasing shares for a variety of reasons. Firstly, when you trade CFDs, you do so on margin. This means you can effectively take out positions that are worth a whole lot more than the funds you have in your account. If used effectively it is possible to make considerably larger profits than what a share trade would allow. Conversely, unmanageable losses can also be incurred so it is important to manage positions effectively.
Another key feature of the CFD is the fact that you can both buy and sell. When you buy a contract you are essentially backing a share price to rise and the more it goes up, the more you will benefit. If you think a share price will fall then you can ‘sell’ and any decrease in value will benefit you. Many people sell (or go short) with Contracts For Difference to hedge against movements that would negatively affect stock they hold
Spread betting is most popular in the UK where its users can take advantage of the extremely attractive feature of tax free winnings. Having said this, it is also prominent in various other countries including Australia, Singapore, Germany, Poland and a number of other areas of Europe.
Another key benefit of spread betting is the fact that you can go short as well as long. If you think a share price is going to go down in value, it is possible to bet on it doing so. In this sense, spread betting is similar to both CFD trading and stock options (which we will come onto shortly).
How does spread betting work?
When you take out a spread betting position, you begin by deciding on what stock you are going to trade and whether its price is going to rise or fall. This will determine whether you buy or sell. Next you will choose how much you want to bet per point. If you buy, for every point the stock goes up, you will make your stake, while for every point it goes down, yup you’ve guessed it, you will lose your stake. If you were to go long on BP at £5 per point and the price fell by 50 points, you would incur a loss of £250.
As you can see, spread betting and CFDs are fundamentally very similar.
The option is an extremely popular way of speculating on the financial markets, especially in the USA where it was first developed. There are two main types of options contracts but in this guide we will be discussing vanilla options rather than binaries.
A stock option gives the buyer, the option to purchase a pre-determined number of shares in a company within a set amount of time. As the name implies though, the buyer isn’t required to complete on the purchase if the company’s share price goes against them. If this were to happen then the holder of the contract could let the option expire and no further action would be taken. The broker will charge a premium for taking on the risk of the option and this will be factored into the purchase price at the offset. This is the maximum loss the buyer can incur.
Summary: As we have seen there are a number of credible alternatives to purchasing stock outright that include Options, CFDs and spread betting. There are many benefits to be taken advantage of, namely:
- The ability to short stock.
- Limited risk (with options)
- Market choice. Most companies allow you to speculate, not just on share prices, but on a wide variety of assets like oil, gold, and commodities.
Each of the three instruments discussed are fundamentally similar with the only real differences being with the option that allows for unlimited gains by paying a fixed premium and certain tax advantages that arise with spread betting.
This article was authored by Marcus Holland – editor of FinancialTrading.com.