The "Myth" of Tax Free Spread Betting Profits

Yesterday I had an email from a prospective client of my course asking me if I recommended opening both a real brokerage account and a Spread Bet account at the same time. The reasoning behind this idea was to take advantage of both the level of real market information offered by the broker, and the tax free profits promised by the spread betting outfit.

Before getting to my response, we need to take a little aside here and explain the concept of financial spread betting for those who perhaps have not come accross it. The idea is in fact very simple. A spread betting company, such as CMC or E*Trade to name a couple of well known businesses, offer their own set of derivative products based on real financial instruments. These products are priced based on the market price of the underlying instrument.

These derivative products are to all intents and purposes, exactly the same as CFDs (Contracts For Difference), which more people are probably familiar with. So for example, a spread betting company might offer an instrument which they call "IBM", which (more or less) mirrors the stock price of IBM. When you buy and sell this product, you are not buying shares in IBM itself, but you still profit from the price movement of IBM stock. Such products are usually offered for common shares, stock indices (Dow, S&P, FTSE etc), futures, and currencies. The difference between a CFD derivative and a Spread Bet product, is simply the name. By calling the product a Spread Bet, under UK tax law, any profits gained from trading it are free of tax. This is why the product is much more well known in the UK than the US, where Spread Betting is not legal.

So, back to the question posed, and my response. Whilst I think CFDs and Spread Betting offer an excellent way into the markets for those who don't have the means to open a real brokerage account, I would not recommend them to anyone who can open a "proper" account. There are two reasons for this.

The first reason is down to the fact that the Spread Bet companies make their own prices. Rememember, if you trade with them, you are trading their own proprietry derivative product, not the actual underlying share. Therefore you cannot accurately use real-market data to make trading decisions about a Spread Bet derivative. Logically, it is in the Spread Bet companies interest that they make money, which generally involves you losing it. That is an over-generalization, and of course these outfits hedge their positions in the real market so they will make money whatever the outcome of your trade. But for the purposes of this article, it is enough to understand that a Spread Betting company is under no obligation to accurately follow the underlying price in real time. The implications are fairly self explanatory!

The second reason is quite simple. Tax-Free profits are great in theory, but in order for your profit to be tax-free, you need to actually make a profit. I know that's an obvious thing to say, but what may not be so obvious is that due to the limitations of spread betting products already mentioned, plus other limitations such as larger spread, smaller choice of trading products, and so on, making a profit with the Spread Bet companies is more difficult than in the real market.

As I said earlier, I have no hesitation recommending Spread Betting to those who may not have the capital required to open a brokerage account. But I would not recommend it purely for the purposes of avoiding tax. You can make more money by trading the real market and paying tax on those profits, than by trading a Spread Bet account tax free.

Harvey can be contacted via his website, where you can also read about his day trading course

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