A Beginners Guide to Spread Betting

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Introduction

This article refers to financial spread betting. This means that we are talking about stock, index, future, forex, treasury, commodity and market sector spread bets. If you are looking for information about sporting spread bets then unfortunately this article will be of no use to you.

Depending on your geographical location and the legal jurisdiction you fall under, spread betting may or may not be available to you. For example, gambling laws in the US may prohibit spread betting as it is classified in the same bracket as visiting a casino.

Spread betting has evolved in, and is dominated by, specialist UK firms. The concept was first introduced over 30 years ago when a bookmaker devised a way of betting on futures indices. The evolution has continued to the present day with greater competition for business creating an increase in financial products on offer and tighter spreads (the difference between the bid and the ask/ offer price). So why has spread betting taken off in the UK while it has remained relatively unheard of in other parts of the World? It is because UK tax laws class gambling (spread betting is classified as gambling, hence the name ‘bet’) as being free from capital gains tax. And as you never take physical ownership of any contacts or shares there is no stamp duty payable. This financial niche has been the major contributing factor to the growth in the spread betting market.


What is Financial Spread Betting?

In the simplest of terms, placing a spread bet means to put a ‘bet’ on a financial instrument moving higher or lower in value. Obviously the idea is to bet in the direction you think that the price will move. This method of speculation differs from the open market, as you will never physically own any security. Spread betting is becoming increasingly popular with investors and traders alike for a number of reasons. In this tutorial we will do our best to show you how spread betting works, the similarities and differences with open market trading and the associated advantages and disadvantages.


Overview

Those with any experience of the financial markets will know the process of opening and closing a position on the open market. For example, if you were to purchase (or borrow in the case of shorting) shares your broker would quote you a price. Once you complete the transaction either by phone or electronically you would then take physical ownership of the shares (however share certificates are now held in street name). This process of opening a position is the same should you wish to place a spread bet. You can open bets by telephone or use the on-line 'trading' platforms provided to you when you open an account. The difference is that opening a spread bet position means that you trade or invest in any of the instruments offered to you without ever taking physical ownership of them. This is because, as we have already mentioned, you are merely putting a bet on the direction that you think they will move. The fact that you never own a single share means that you forfeit any voting rights attached to the stock. It does not mean that you forfeit your right to a dividend payment however. Spread bet firms will adjust you position higher for a dividend payment (and mark it lower if a company goes ex dividend). At the time of writing it is not clear if this is an industry wide standard so it is worth checking with your chosen spread bet firm.


Shares vs. � per Point

A fundamental difference in the way you place a spread bet as apposed to an open market order is the quantity you deal in. Rather than buying and selling no. of shares, you will be operating in GBP (�) per point. The definition of one ‘point’ depends on the spread bet firm in question but it is usually one pip in forex and one penny (UK) or one cent (US) for shares. We will go into detail in our examples section about how you can convert your position size from �/ point to the equivalent of number of shares or contract size.


Shorting

If you have ever traded during a bear market or an IPO you will know that restrictions are placed on short positions. This is either because brokers have no shares left available for shorts (am many of their clients are already short) or the exchange has prohibited shorting. There are no such restrictions when it comes to spread betting. You are free to short (place a bet on price/ value falling) as often as you like and during any market conditions.


Available Markets

Although you will not find restrictions on your shorting activity there is a strong possibility of restrictions on the number of instruments available to bet on. If you specialise in penny shares, junk bonds or less liquid stocks you will more than likely find yourself frustrated. Most spread betting firms will offer you the opportunity to bet on mainstream indices (the DJIA, S&P 500, NASDAQ 100 and FTSE for example) and their member stocks. However, lower valued stocks are likely not to be offered. For example you will find yourself able to bet on the constituents of the NASDAQ 100 but members of the NASDAQ Composite are less frequently available.


Financial Incentives

We have already mentioned the tax benefits associated with spread betting but there are also other financial incentives. Spread betting firms charge no commission, there are no ECN fess and exchange fees do not apply. Spread bet firms make their money from the spread they charge. Therefore, the larger the spread the greater your cost to trade. If we take these firms at their word then they are constantly hedged in the market against their clients ‘overall’ positions. This means that they have no vested interest in seeing you make a loss because they are not on the other side of the bet. In fact they want to be profitable as it guarantees more bets (and the cost of spread) for them. A less optimistic view is that spread bet companies are no more than bookmakers and make their profit based on the fact that the majority of traders (and gamblers) lose money. This point will be discussed more in depth later on.

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Trading Platforms

In order to make the spread betting experience as much like open market trading as possible, spread bet firms have invested heavily in their online trading platforms. These programs include live streaming quotes, free live charts (including technical indicators suitable for all but the most advanced technical traders), news wires and order tickets featuring stop, limit, OCO, market and CRB (controlled risk bets that act as a guaranteed stop loss) orders. These platforms are provided at no extra cost when you open your account, however features will vary depending on your provider.


Live Prices

The live streaming quotes are not fixed in order to catch you out while betting. All quotes are based on the current market price. The only difference is the spread as the spread bet firms are free to set this themselves. As we have mentioned this is their primary source of income and you may find spreads are a little wider than you will find in the open market. However, competition for your custom has been increasing rapidly and you will find that the spreads on offer are very competitive.


Margin Requirements

Spread betting affords traders a much lower margin requirement than typical share dealing accounts. For example, SEC rules stipulate that brokers inside the US may only provide leverage of 4:1 (25% margin) on accounts over $25 000. This means that in order to command positions worth $100 000 you must have a minimum of $25 000 in your account. With spread betting firms the margin requirement is much lower. One leading spread bet firm requires you to provide 5% margin for US share bets. Using the same example a $100 000 position would only require $5 000 account balance. Of course this position would be calculated in £ per point and not dollars. The relaxed margin requirements allow traders to command much larger positions with their available account balance. In theory this means a trader can achieve a much higher return on capital but must do so by accepting much higher risk.


How Does it Work? – Examples

As we have already mentioned, spread bets are denominated in £ and points rather than number of shares. This difference may be confusing but with a simple equation you can convert the £ per point trades size to the equivalent number of shares. For this example we will be using Vodafone (UK), VOD. It is currently trading at 116.00 / 25 pence. The spread, as quoted by your spread bet firm is currently 0.25 pence, or a quarter of one point. You wish to buy the equivalent of 100 shares of VOD. You have a target of 146 pence. If you were to buy 100 shares on the open market it would cost you 116.25 multiplied by 100 = 11625 pence or £116.25. Every penny the share moves will alter the value of your position by £1 (1penny * 100 shares = £1). Therefore £1 per point will give you the equivalent of 100 shares. This is the same for all share bets, including US shares because spread bet firms denominate US shares in points and the number of pounds you bet per point move.


Gambling vs Trading

The name spread betting automatically conjures up thoughts of gambling due to the word ‘bet’. This is confirmed by the UK government who have classed any profits made in a spread betting account as being free from capital gains tax. However, no trading or investing decision ever includes thoughts of gambling. This should also be true for any one hoping to venture into spread betting. In truth we should refer to 'spread betting' as 'spread trading'. The system has been set up to mimic open market trading as closely as possible and therefore lends itself to the same profitable strategies used in the open market. Strict risk reward and discipline are key. The same price movements, technical criteria or fundamentals exist; you are simply acting on your strategy through a different medium.

Without venturing too far into strategy building and implementation, it must be remembered that the smaller margin requirements, especially for stocks, must be incorporated into the risk factor of each trade.


Summary

For any trader looking to investigate the possibilities of spread betting there are certainly benefits and detriments to consider. Indeed it may not even be possible for many as gambling laws prohibit the use of spread betting accounts.

The potential for increased risk is one such consideration. The spread bet firms are keen to illustrate the fact that a smaller margin requirement can lead to massive return on your account balance through superior leverage. However, in truth this extra leverage may not be needed, as a successful strategy will not increase the risk placed on a trade just because it is possible. This makes the benefit of increased leverage almost obsolete unless you wish to be able to maintain your positions with a smaller account balance, thus freeing up funds for other investments.

On the other hand, any profits made through spread betting are currently classed as tax free (tax laws can change). The profit saved thanks to this lack of tax is a heavy consideration for most, although it must be noted that any losses incurred cannot be claimed back against your tax bill for the year.

There is slight resistance to the spread bet movement; those who disapprove claim that it robs the market of liquidity as more and more traders choose spread betting over open market trading. However, if spread bet firms hedge their clients’ positions in the open market, as many of them claim to do, this liquidity would find its way back into the market. Therefore it must be the case that spread bet firms do not hedge or there is no loss, or at least very little, of liquidity.