What is spread betting and how does it work?

How does spread betting work?

Spread betting offers investors 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 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, investors 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 investor’s chosen direction, the more profit is made. However, the opposite is also true, with the more the price moves against an investor’s chosen direction, the greater the loss.

Understanding the spread

Spread betting offers investors 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, investors 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 an investor’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 investor, with losses also being multiples of the stake.

For instance, if an investor 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 investors 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 investor’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 an investor is betting on the asset’s value rising.

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

Going short in spread betting

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

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

Leverage in spread betting

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

For instance, if an investor 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 an investor 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.

Investors unfamiliar with leverage may inadvertently overextend themselves, leading to margin calls and significant losses. It’s advisable, therefore, for investors 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 an investor’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 an investor 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 investor’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 an investor 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 investor’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, investors limit potential losses, safeguarding their capital from significant downturns.

Benefits of spread betting

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

Spread betting is ideal for investors 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 investors. 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 investors 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 investors off guard. This widening can trigger stop-loss orders prematurely and inflate trading costs, eating into profits. Therefore, investors 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 investors in their wake.

Spread betting example: Nvidia

Let's delve into a scenario where an investor anticipates a surge in Nvidia's stock value, possibly due to an impending product launch. To capitalise on this, the investor 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 investor 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 investor’s entry. In this scenario, the investor’s judgement aligns with the market. With each point translating to £10, the investor 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 investor’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 investor’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.