What is spread betting and how does it work?

How does spread betting work?

Spread betting offers traders an alternative to physically buying, holding and selling an asset by giving them the opportunity to instead place a bet on simply whether its value will increase or decrease.

Traditionally, an investor or trader that wishes to gain exposure to an asset like Microsoft, for example, would buy Microsoft stock, hold it until its value increased, and then sell it to make a profit.

With spread betting, traders are able to gain exposure to an asset and make profit by placing a bet on whether its price rises or falls. The further the asset moves in an trader's chosen direction, the more profit is made. However, the opposite is also true, with the more the price moves against a trader's chosen direction, the greater the loss.

Understanding the spread

Spread betting offers traders the opportunity to buy or sell tradable instruments from either bull or bear markets - but what is the spread?

The spread refers to the gap between the bid (buy) and ask (sell) prices on a market. It represents the cost of opening a spread betting position, encompassing all trading expenses within this price difference, thereby eliminating the need for separate commission fees.

For example, the S&P 500 index might exhibit a spread of 2 points. This implies that the buy price is set at 1 point above the current market price, while the sell price is 1 point below it.

Consequently, the fees charged by a spread betting platform provider for opening and closing a position are included within this 2-point spread. This embedded cost structure simplifies the trading process, as it consolidates fees into the spread itself.

Understanding the bet size

In spread betting, traders determine their bet or ‘stake’ which signifies the amount of money put at risk for each point of fluctuation in the underlying asset’s price. Each ‘point’ denotes a unit of change in an asset’s value.

When the price of an asset moves in a trader's favour, profits are calculated by multiplying the stake by the number of points the price has shifted.

Conversely, losses are incurred when the price moves against the trader, with losses also being multiples of the stake.

For instance, if an trader bets £1 per point on the S&P 500 and it rises by 100 points from 5,290 to 5,390, the profit would amount to £100 (£1 x 100 points. Conversely, a 100-point decline would result in a £100 loss.

It’s important to note that profits or losses are calculated based on the entire position’s value, meaning losses may exceed the initial margin required to open the trade.

The minimum stake for an asset typically starts at £0.10 per point, with larger stakes increasing exposure to both the asset and the market being traded. For example, a £10 per point bet would yield ten times the outcome of a £1 per point bet. This allows traders to customise their risk management strategy.

Understanding duration

Spread betting is a popular trading strategy known for its short-term nature. Unlike traditional investment with fixed durations, spread bets can be closed at any time during trading hours. The duration of an trader's bet depends on the type of trade they choose.

Spread betting offers three main types of trades based on duration:

1. Daily Funded Trades (DFTs) allow flexibility in choosing when to close a position, but entail daily overnight financing fees.
2. Forwards have a predetermined expiry date, usually at the end of a quarter, but can be closed before that as long as the market is open. While there's no overnight financing, spreads are wider.

Consideration of costs and fees is crucial in developing a trading strategy to maximise returns.

Going long in spread betting

When anticipating an increase in the value of an asset, one strategy is to initiate a long (buy) position. This means that a trader is betting on the asset’s value rising.

If the trader's prediction aligns with the market movement, the trader stands to gain profit. However, if the market goes in the opposite direction, the trader will incur a loss.

Going short in spread betting

In contrast to traditional share dealing, spread betting offers traders the opportunity to short (sell) an asset if they anticipate its value will drop. This strategy, known as ‘going short’, enables traders to capitalise when an asset’s price declines.

For instance, suppose an trader has a bearish outlook on the price of gold. Through spread betting, that trader can initiate a short position to sell the underlying market. In this example, if the market indeed experiences a decline, the trader's bet would generate a profit. Conversely, if the price of gold rises, the trader's position would incur a loss.

Leverage in spread betting

Spread betting offers traders the opportunity to access the market with only a fraction of the upfront cost. Through leverage, traders can control larger positions than their initial deposit would typically allow, maximising exposure while minimising the capital required.

For instance, if a trader wished to trade Facebook shares conventionally, they would need to pay the full share price upfront. However, with spread betting, they might only need to commit, say, 20% of the total value as a deposit.

Taking Facebook stock as an example, a 20% deposit could allow a trader to control a position equivalent to the entire value of the shares, resulting in a leverage ratio of 5:1. In contrast, markets like forex can offer even higher leverage ratios, sometimes reaching 20:1 or more.

It’s crucial to recognise that while leverage magnifies potential profits, it equally amplifies potential losses. Therefore, effective risk management is paramount.

Traders unfamiliar with leverage may inadvertently overextend themselves, leading to margin calls and significant losses. It’s advisable, therefore, for traders to limit their risk exposure to no more than 2% of their investment capital per trade and to thoroughly understand the potential position value before initiating any bet.

Margin in spread betting

Leveraged trading involves maintaining a deposit in a trader's account known as margin to keep positions open. This concept is often termed 'trading on margin'. Maintaining sufficient margin is crucial in leveraged trading to prevent position closure.

For instance, let’s say a trader wishes to speculate £10 per point on the FTSE 100 at 7,500, leveraging at a ratio of 20:1. Their position size would be (£10 x 7500) £75,000, necessitating a margin of (5% of £75,000) £3,750. It's imperative to always maintain at least 5% of the total value of the trader's position in their account to sustain the position.

There are two key types of margin in spread betting:

1. Deposit Margin: This initial funding is necessary to initiate a position and is typically represented as a percentage of the total trade.
2. Maintenance Margin: As losses accumulate beyond the initial deposit, additional funds may be required. A margin call is issued, prompting a trader to add funds to avoid position closure.

Margin requirements fluctuate based on market movements. Rising prices demand higher margins, while falling prices decrease margin needs. Sustained losses may deplete an trader's account value, potentially leading to insufficient coverage for margin requirements, resulting in close-out or liquidation.

Margin rates in spread betting vary across markets. For example, trading shares might entail a 5% margin, whereas forex trading might require 20% of the trade size.

Managing risk in spread betting

In the realm of spread betting, prudent risk management stands as the cornerstone of success. It begins with a thorough assessment of potential trading hazards followed by the crafting of a comprehensive risk management strategy tailored to each trading position.

While the utilisation of high leverage introduces inherent risks, spread betting offers an effective risk containment tool:

Standard Stop-Loss Orders: These orders function by automatically closing out a trade once the market hits a predetermined price level. However, during periods of heightened market volatility, there's a possibility that the trade may close at a less favourable price than anticipated.

Implementing stop-loss orders is paramount in controlling risk. By setting a predefined exit point for each trade, traders limit potential losses, safeguarding their capital from significant downturns.

Benefits of spread betting

Spread betting offers numerous advantages for traders looking to maximise their investments.

Spread betting is ideal for traders interest in:

• Trading short-term opportunities
• Trading tax and commission free
• Utilising leverage
• Hedging risk
• Trading bear markets (going short), as well as bear markets (going long)
• Accessing out-of-hours trading

Limitations of spread betting

Leverage can be a double-edged sword for traders. Without a firm grasp of how it works, they might inadvertently overexpose themselves, inviting dreaded margin calls that demand more capital or liquidation of positions. It's crucial for traders to limit their risk, ideally to no more than 2% of their investment capital per trade. Further, understanding the full value of the position they're about to open is paramount to avoid unpleasant surprises.

In times of market turbulence, spread betting providers tend to widen their spreads, potentially catching unsuspecting traders off guard. This widening can trigger stop-loss orders prematurely and inflate trading costs, eating into profits. Therefore, traders should exercise caution, particularly when placing orders just before major events like company earnings releases or economic data announcements. These moments of heightened volatility can significantly impact market dynamics and catch ill-prepared traders in their wake.

Let's delve into a scenario where a trader anticipates a surge in Nvidia's stock value, possibly due to an impending product launch. To capitalise on this, the trader opts for a spread bet on Nvidia's stock.

Currently, the bid-offer spread for Nvidia sits at £200.50 - £201.00.

Taking a bullish view, the trader decides to go long on Nvidia and, therefore, places a bet of £10 per point at the offer price of £201.00.

Now, envision two potential outcomes:

Scenario 1 - Nvidia's stock price rises:

Suppose Nvidia's stock surges to £210.00, marking a 9-point increase from the trader's entry. In this scenario, the trader's judgement aligns with the market. With each point translating to £10, the trader makes a total profit of £90 (£10 x 9).

Scenario 2 - Nvidia's stock price declines:

Conversely, if Nvidia's stock dips to £195.00, reflecting a 6-point decrease from the trader's entry, they will suffer a loss. With each point valued at £10, their loss amounts to £60 (£10 x 6).

In spread betting, an trader's gains or losses hinge on the variance between the closing price and their entry point, multiplied by their stake. It's vital therefore to grasp the inherent risks of spread betting.

Spread betting FAQs

Can I make a profit in spread betting?

Spread betting involves speculating on market movements, with gains or losses depending on the accuracy of those predictions.

Spread betting involves the risk of losses that can exceed the initial investment, highlighting the importance of cautious participation and trading only with disposable funds. Although many traders achieve success in spread betting, it requires dedication, education, and disciplined risk management to maintain profitability, with the understanding that losses are also possible.

What can I spread bet on?

Pepperstone provides access to 1,200+ assets for traders to spread bet on, catering to a diverse range of trading preferences, including:

• Stocks: Traders can spread bet on individual stocks like Apple, Microsoft and Nvidia, or entire indices, such as the S&P 500, FTSE 100 and NASDAQ.
• Forex: Spread betting on currency pairs allows traders to speculate on the exchange rate movements between two currencies, like EUR/USD or GBP/JPY.
• Commodities: Precious metals like gold and silver, energies like oil and natural gas, and agricultural products like wheat and coffee.
• Interest Rates: Traders can spread bet on the future direction of interest rates, such as the LIBOR or Federal Funds Rate.

Is spread betting tax free in the UK?

In the UK, spread betting is tax-free from both stamp duty and Capital Gains Tax. Typically, Traders face levies on profits made from buying and selling shares, but these taxes do not apply to spread betting. It's important to note, however, that tax regulations are dynamic and subject to the possibility of changing. For more information on the latest changes to Capital Gains Tax and how spread betting may benefit UK traders facing a Capital Gains Tax (CGT) increase, see Pepperstone's latest guide.

How can I hedge with spread betting?

The process of hedging with spread betting entails opening a spread bet that yields profits if an existing open position incurs losses.

When employing hedging strategies through spread betting, a trader will initiate a position that counteracts potential adverse price movements in an existing position. This could involve trading the same asset in the opposite direction or opting for an asset with a divergent trajectory compared to their current trade.

For instance, let's say a trader holds shares in Tesla within their investment portfolio. If they anticipate a temporary downturn, the trader might contemplate selling their shares, risking the loss of their position in the company.

Alternatively, rather than divesting their shares, the trader could initiate a short spread bet on Tesla. Consequently, should Tesla’s stock price decline, the loss in the trader's portfolio could be offset by the gains from their spread bet. This approach allows a trader to hedge against potential losses while maintaining their position in the company.

What is a spread bet example?

Imagine that ABC stock is currently priced at £201.50. A spread-betting firm offers a fixed spread and quotes the bid/as prices at £200/£203 for traders interested in trading.

A trader, anticipating that the stock's price will drop below £200, decides to sell at the bid price of £200. They wager £20 for every point the stock declines below their selling price of £200.

Should ABC's price drop to a bid/ask of £185/£188, the trader can exit the trade with a profit calculated as (£200 - £188) x £20 = £240. Conversely, if the stock price rises to £212/£215 and the trader opts to close the trade, they would incur a loss of (£200 - £215) x £20 = -£300.

Further, if the spread betting provider mandates a 20% margin, meaning the trader must deposit 20% of the initial position's value. The position's value is determined by multiplying the stake per point by the stock's bid price: (£20 * £200 = £4,000). Therefore, the trader needs to deposit 20% of this value, which amounts to £4,000 x 20% = £800, into their account to cover the bet.

Is spread betting illegal in the UK?

No. Spread betting is legal in the UK and is regulated by the Financial Conduct Authority (FCA) as a trading activity.

Spread betting is considered a form of gambling in certain jurisdictions, such as the US. In such cases, gains realised from spread betting may be treated as taxable earnings. Traders

engaging in spread betting are advised to maintain trading records and consider consulting with an accountant to ensure compliance with tax obligations.

Which is better, CFD or spread betting?

Neither are better than the other. Contracts for Difference (CFDs) and spread bets are simply financial instruments used for speculating on the price movements of various assets without owning the underlying.

Spread betting involves wagering on the anticipated movement of a market's value, whereas a CFD is a contract that entails exchanging the variation in an asset's price between the opening and closing times of the contract.

Both spread betting and CFDs are derivative financial instruments, sharing several commonalities and distinctions.