Spread Betting 101
Financial spread betting allows you to benefit from the movement in the price of shares, commodities and a number of other financial indices and markets, without actually purchasing the individual investment itself.
The ‘spread’ referenced is the difference between the price the spread betting company will pay for a stock and the price it will sell it for.
The spread betting sector is highly competitive with companies competing to woo customers with the most attractive (‘tightest’) spreads on shares; the spread is measures in points or ‘pips’.
Spreads are regularly updated relative to the shares’ actual stock market valuation and any profit, or loss, is based upon the difference between the new spread prices and the price you invested at.
A key feature of spread betting is that you can go ‘short’ on a stock or index – i.e. bet that its value will go down allowing someone who has invested in a particular stock in a traditional way to use a spread bet as an insurance or hedge; if the share price falls, the value of the equity holding declines, but the short spread bet pays out, and the greater the fall, the greater the return.
‘A key feature of spread betting is that you can go ‘short’ on a stock or index’
In order to begin trading you will need to open an account with a spread betting company which will require you to deposit a sum of money or open a line of credit with which you can trade.
There are a range of different accounts available, some with minimum initial deposits, aimed at different types of investor.
Many companies will offer incentives for you to open an account with them, such as matching your initial deposit, or offering bonuses for frequent traders; your choice of provider could be influenced by the size of the initial sum you want to invest, the incentives offered by a company, and how competitive their spreads are.
Generally it is better to have narrower spreads because even small movements in a share price may present the opportunity to sell, or buy back, shares at a profit.
Spread Betting in Action
When spread betting you are gambling on the movement of the price, up or down, of a share, or index, and your profit depends upon the degree to which you are right – the more the price moves in the direction you predict, the bigger your profit; the converse is also true.
‘the more the price moves in the direction you predict, the bigger your profit’
If you believe that the value of a share will rise compared to that quoted by the spread betting company, you ‘buy’ that stock; when spread betting, you never take physical ownership of the share, as a ‘derivative’ your profit or loss depends upon, or is derived from, the performance of something else.
You invest a stake per point of movement (‘pip’) in the price of that stock.
The price at which you buy a stock is the higher price that is quoted in the spread, so you cannot sell your stake back, and thereby make a profit, until the sell price moves above the price you bought at.
Your profit is the number of pips the spread’s sell price moves above its buy price multiplied by the amount you bet per pip – perhaps £1.
If you believe that the value of a share will fall, you ‘sell’ that stock, in the hope that you can buy it back later for less.
The process is as above, but in reverse – once the ‘buy’ price falls below the price you sold at, you can buy the shares back for less and your reward represents the number of pips below your sale prices multiplied by the size of your stake per pip.
If the price of the share or index goes in the opposite direction to your prediction, your loss represents the number of pips it has moved against you multiplied by the size of your stake; you should be fully aware of the magnitude of any potential losses before you begin spread betting.
Bets can be closed at any time to crystallise a profit or limit a loss; markets can move very quickly, delivering the potential for quick wins, or losses, and with no limit to the number of pips an investment may rise, potential profits are uncapped.
If you correctly predict the direction of a price movement your returns can be magnified but if you get it wrong your losses will be greater too which means that financial spreads can be a very volatile investment.
Spread betting platforms offer tools such as ‘stop loss’ orders to allow you to protect against the risk of a big loss where your bet is automatically closed if the index moves a specified amount against you.
Spread betting accounts allow you to place a bet and pay a deposit rather than the full bet amount, which means that you are able to stake a larger position on each point in the bet than you would have been able to otherwise; this is also known as gearing.
If the bet goes against you the company will need to be assured that you can cover the full cost of the bet so you may either have to lodge money on account, or have a line of credit agreed with the broker.
Despite the fact that financial spread betting is based upon instruments that are traded on exchange, because it is high risk it is classed as gambling and is therefore exempt from capital gains tax and stamp duty thereby protecting your profits.
Spread betting can deliver potentially unlimited profits in double quick time, but it is also highly risky; the DIY investor should only consider it if any losses would not do irreparable damage to their wealth and they have the ability to access to the finance should they incur any losses.
In the same way as potential profits, losses are also unlimited and spread betting without placing limit orders could be considered foolhardy.
‘In the same way as potential profits, losses are also unlimited’
It is important to fully understand the potential pitfalls before taking any position and make sure that the tools offered by your chosen provider give you the security you want; most providers will allow you to trade on dummy accounts to familiarise yourself with their platform and the concept before you start to stake your hard-earned.
Financial spread betting should only be undertaken with money you can ‘afford’ or are prepared to lose and should therefore be conducted outside of a long term investment strategy; if you decide to take a gamble, research your bet well and set limits against big potential losses.