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Financial Spread Betting


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Spread betting is not an investment; it is a form of gambling. This guide to spread betting explains how it works, what the disadvantages and advantages of spread betting are and highlights the key facts you need to remember about spread betting.

What spread betting is and what it is not

The first key point to remember about spread betting is that it is gambling. It is NOT investing, it is not trading. Let me reiterate, it is gambling. It involves a high level of risk. You stand to lose more than your original stake and should never bet with money that you cannot afford to lose.

Financial spread betting is a relatively new phenomenon, the first market being created in 1974 by former barrister Stuart Wheeler on the price of gold. Wheeler went on to found what became IG Group, the UK's first spread betting firm. The first sports spread betting followed in the mid-1980s.

Spread betting has been described by some as the crack cocaine of gambling. (Source: Financial Times 11/10/04). So what's the attraction? Well, you don't know how much you are going to win or lose when you place your bet. The outcome is completely dependent on the movement in the value of the underlying asset you are betting on.

In spread betting, the more you are right, the more you win and the more you are wrong, the more you lose.

Spread betting should never be undertaken unless you have a clear understanding of the risks of this type of gambling, otherwise, it might just be wiser to take a wad of £5 notes and burn them in the street.

Risk Warning - Financial spread betting involves a high level of risk and you can lose more than your original stake. It is not suitable for everyone so please ensure you understand the risks involved and only bet with money you can afford to lose.

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What is the spread?

You should be familiar with the difference between the buying and selling price of shares (and if you're not at least comfortable with buying and selling shares you should not even be considering spread betting). In fact the price of all financial assets is quoted as a spread, with a buying price and a selling price.

A spread bet is simply a bet on the future movement of the price of the underlying asset. A spread betting bookmaker will have made predictions about where the price is going to go. You then decide whether that prediction has been pitched too high or too low.

The predictions are presented in the form of two prices. This gap between the two prices is the spread and is, in effect, the spread betting company's margin. You have a choice of betting 'down' (also known as a 'sell') at the first named lower price or betting 'up' (also known as a 'buy') at the second higher price.

You are not actually selling anything, what you are doing is betting that the lower value of the quote will be breached. Neither are you actually buying anything, you would be betting that the higher value of the quote would actually be exceeded.

For example, if someone asked you to guess their age, you might say somewhere between 35 and 38 years old. You have effectively given a spread of 35-38. A spread betting bookmaker would offer the option of selling at 35 or buying at 38.

Do bear in mind that what is happening with spread betting is that the bookmaker is effectively staking a claim to what it believes will be the most likely outcome, whether its a share price, a stock market index, a currency, a house price index, a commodity price or even a sporting event.

Of course, things don't always turn out the way the bookies expect them to; some spread bets have been scrapped because of insider trading. One notable example happened on a sporting spread bet based on the timing of the first throw-in in a certain football match. (Source: The Times 22/01/05). The players were in on it and put the ball straight out of play!

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What are the risks of spread betting?

There is a better than good chance that you will end up losing your outlay as the odds are stacked in favour of the spread betting companies.

Unlike conventional, fixed-odds gambling, you stand to lose more than your original stake. If you went to a bookmaker and put down a £10 bet you could lose no more than that £10. But with spread betting a £10 bet could quickly cost hundreds of pounds.

Depending on whom you believe, the odds can be quite heavily against you making any money through spread betting.

Simon Denham, managing director of Capital Spreads, is on record as saying, "It's generally considered that about 80 per cent of bets lose... However, of the 20 per cent that win, some make very high returns on their money.'' (Source: Sunday Telegraph, 27/02/05).

Alexander Davidson, author of How to Win as a Stock Market Speculator, disagrees. He reckons, "About 97% of people lose money when they spread bet." (Source: Sunday Times, 07/03/04).

Spread-betting companies deny that the risks are not clear and that the odds are heavily stacked against investors. But they do admit that 40% to 50% of trades result in a loss. (Source: Sunday Times, 13/02/05).

Remember, spread betting is gambling not investing. This means that you may not offset any losses against tax and you are legally obliged to pay up.

So just how much could you lose? That depends on how much you bet. Bet each point in the spread at a pound and for every point the outcome moves in the opposite direction to your bet, you will owe the bookmaker a pound. Bet £10 a point and be 10 points out and you will owe the bookmaker £100. See how easy and how painful that was?

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What are the benefits of spread betting?

Spread betting is gambling, not investing. This means that your profits are free of UK Capital Gains Tax (although of course tax rules can change). It also means there is no stamp duty or commission / brokerage fee to pay.

Compared to fixed odds betting, spread betting is more flexible. You are not waiting for a specific event to take place. You may also settle or 'close' a bet at any time, to take profit or restrict a loss.

When you place a fixed odds bet you are stuck with it until the event is done. Then you've either won or lost. The nature of spread betting is that neither your winnings nor your losses are set. Spread betting can be very rewarding and produce large returns on small stakes. This means that the more right you are the more you will win. It also means that the more wrong you are the more you will lose.

Spread betting offers you access to markets that individual investors may not otherwise be easily able to take positions in, including currency movements, commodity prices and stock market indices. It also allows you to take a position in a market without having to purchase shares directly and your upfront costs are, therefore, significantly lower.

If you believe prices are likely to fall it offers the ability make gains from falling markets by making a 'sell' or 'down' bet at the lower price in the spread. This could also be used as a way of hedging other investments.

Risk Warning - Financial spread betting involves a high level of risk and you can lose more than your original stake. It is not suitable for everyone so please ensure you understand the risks involved and only bet with money you can afford to lose.

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How can I limit my risk?

First of all you must be sure you understand what you are betting on. Make sure you know what your spread betting bookmaker considers to be a betting unit and be sure you know how the value of the spread is calculated. Both of these factors may vary by spread betting firm.

Your profit or loss is determined by the difference between the final result and the level at which the bet was originally made, multiplied by the stake that you nominated. In some volatile markets, your profit or loss can escalate very rapidly.

You can limit your potential losses by using a either a stop loss / win account or a limited risk account. A stop loss / win account puts a cap on your potential losses but be sure you understand the stop loss rules as they may also limit your winnings, limit the size of a bet if it was to expose you to excessive risk, or in some instances cause a bet to be refused.

A limited risk account is a type of spread betting account where your bet is automatically closed if you reach a certain threshold. While the threshold will vary for different bets, this does mean that you always know the maximum you can lose. However the amount you can win is not capped.

Even if the asset or index you are betting on only makes a small move in the wrong direction, your losses can mount speedily and are limited only by the underlying asset itself.

For example, if you bought £10 a point of the FTSE 100 at 5860, your potential losses, although highly unlikely, would be £58,600. However, if you placed a stop loss at 5785, 75 points below your entry level, your total risk would be reduced to £750. A stop loss order effectively tells your spread betting firm to close out the trade should the sell price fall to 5785, protecting you from further losses.

However, you should bear in mind that ordinary stop loss orders are NOT foolproof - there are times when market moves out of hours could still leave you out of pocket. The wild market gyrations in January and February 2008, with daily triple digit moves for the FTSE 100 up and down, stand out as an example of such times. To protect yourself you may 'guarantee' your stop loss for a small extra fee. Guaranteed stop losses do what the name says and guarantee that you wont lose more than the stop loss limit.

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What kind of spread betting account should I consider?

"Statistically, the average punter is a loser. This is a fact. So, before opening a spread-betting account, at the very least be aware of this statistical probability." (Source: Investors Chronicle 21/01/05).

Opening a spread betting account is more complicated than wandering into a bookmaker and placing a fixed odds bet. Spread betting accounts may involve extending you some form of credit, and also they are regulated by the Financial Services Authority, so there is a formal application process that may involve you being required to produce documentation, and you are not guaranteed to be accepted.

There are two basic types of spread betting account: the no stop loss account and the stop loss account. If you open an account without a stop loss facility you will be able to place larger bets with greater potential winnings and greater potential losses. However, some spread betting firms will not allow clients to trade unless a stop loss is in place.

A stop loss account offers you the added security of limiting risk. Every bet placed through a stop loss account is subject to a maximum stop loss. This means you will know the most you can lose every time you place a bet. A stop loss account will also offer you the option of smaller minimum stakes.

All spread betting firms offer the option of online betting and some also offer demonstration accounts allowing novice gamblers to bet with 'virtual' money to allow them to gain an understanding of how spread betting works. Any beginner to spread betting should start with an account that offers some way of limiting risk.

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What is margin?

Trading on margin allows you the potential of far greater returns (and far greater losses) than are possible through buying shares outright. For example, if you owned £1,000 of shares which rose in value by 10% to £1,100 then the value of your investment, to state the obvious, has risen by 10%.

However, spread betting firms allow you to place a bet with a deposit known as the initial margin. Typically this deposit will be equivalent to, say, 10%. Thus a spread bet on the same position would only have cost 10% of the share purchaser's outlay, i.e. £100, to take. A 10% rise in the value of the underlying asset therefore means our spread bettor has doubled his money! Of course, had the price moved down by 10% the spread bettor would have lost all his money.

The exact size of the deposit or initial margin will depend on the type of asset you are betting on. The margin factor is usually a stable number but may be increased at the spread betting firm's discretion if there is an increase in volatility.

Initial margin is not the end of the story. You will also be required to provide maintenance margin. This is a sum of money in your spread betting account which will be several multiples of the deposit margin. It is there as a cushion for the firm to draw out of your account to cover your losses. You may not be allowed to place bets unless you have sufficient maintenance margin in your betting account.

And still this is not the end - by a potentially large margin! If your bet goes against you, the spread betting firm will draw down your maintenance margin. Once that has gone, you will be faced with a margin call. This means you will need to deposit more money in your betting account if you want to keep the bet open.

How does this work? Imagine a highly volatile market where there is a dramatic slump, causing your 'up' bet to go wrong - your deposit margin has gone and your maintenance margin has been eaten up. In these circumstances, your spread betting firm will make a margin call, requiring you to deposit more funds with them to keep the bet open. Of course, you could always close the bet and take your losses.

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How does spread betting work?

Spread bet positions are calculated on a marked-to-market basis. What this means is that the running total of the profit or loss on your bet is calculated or marked in real time as prices move up and down. Your profits and losses are credited and debited to your spread betting account accordingly.

For example, if a spread bettor made an 'up' bet or bought £1 of the FTSE 100 at 5950 at 10.00 am and an hour later it had risen to 6,050, £100 (£1 x 100 points) would be credited to his account. However, if, another hour on the FTSE 100 had slumped to 5850, then £100 would be debited from the account.

These money movements take place in real time. This is completely different to the experience of investing in shares where profits or losses may be described as 'paper' profits or losses until the shares are actually sold and the gain or loss realized and the money resides in the shareholder's account.

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Can I bet on foreign markets?

What you will be able to place a bet on will be limited only by the spreads your chosen spread betting firm is prepared to offer. However, there is one key advantage of spread betting on foreign markets against making a direct investment overseas - there is no currency risk involved, you are simply betting on the spread.

So, for example had you placed a 'down' bet on the shares of Apple at $180 and sold or closed out the bet four weeks later at $120, you would have earned a 33% return on the share price move. Had you purchased the shares outright, you would have faced dealing costs and exchange rate costs.

Furthermore, the return you made on guessing the direction of Apple's share price correctly could have been undermined by an adverse movement in the exchange rate - had the pound weakened against the dollar in the interim you would be getting fewer pounds back for your dollars when converting your profits back into pounds.

Spread betting firms are also seeing growing interest in contracts on indices in India and China - spread betting allows you to take positions that will allow you to reap the potential gains from these rapidly expanding economies while bypassing complex share structures and exchange controls that could limit your direct investment in shares.

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What are the key facts about spread betting?

Spread betting is gambling. You must never bet with money you cannot afford to lose. You should be aware that you can lose much more than your original stake. You may not offset your spread betting losses against tax.

Having said that, there is no fee for placing a bet and if you are a winner then your winnings are (currently) free of tax. Spread betting is more flexible than fixed odds betting and offers the potential for greater winnings but also of greater losses too.

You can win and lose a lot more than your initial stake and for that reason spread betting is actually illegal across most of the world. People who can't afford to lose shouldn't indulge. Make sure you understand how to limit your potential losses with a stop loss account.

Risk Warning - Financial spread betting involves a high level of risk and you can lose more than your original stake. It is not suitable for everyone so please ensure you understand the risks involved and only bet with money you can afford to lose.

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22 February 2008 © Moneyextra.com

 

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