Understanding spread betting
Spread betting is one of the most popular ways for retail investors to trade financial markets. A spread bet is classed as a financial derivative. That’s because you don’t buy or sell the underlying asset. You simply speculate on whether the asset’s price will go up or down by trading a contract whose price is derived from the underlying asset. The term “spread” in spread betting refers to the difference between the buy and sell prices involved in trading.
One advantage of spread betting is the ability to use leverage, which allows you to open a position with a smaller margin deposit instead of the full value of the trade. Additionally, spread betting offers the flexibility to take both long and short positions in thousands of markets, including FX, stocks, indices, and commodities. In the UK, spread betting is exempt from taxes, making it an attractive option for investors.
How does spread betting work?
Spread betting is a form of trading that involves making bets rather than physically buying and selling assets. For instance, instead of purchasing Apple stock and then selling it at a later time, spread betting involves placing a bet on the price of Apple shares increasing.
As the price of Apple moves in the direction you predicted, your profits will increase. However, if the price moves against your bet, your losses will also increase.
What is the spread?
When opening a spread betting position, the cost is determined by the spread, which is the difference between the buy and sell prices available in the market. In other forms of trading, such as buying or selling shares through a stockbroker, the broker may charge you a commission. But in spread betting, the cost of trading is included in the spread.
For example, a FTSE 100 spread bet contract might quote a buy price of 1 point higher than the underlying market buy price and a sell price of 1 point lower than the market sell price. All the charges and fees involved in opening and closing your position are incorporated within the 2-point spread provided by your spread bet provider.
In spread betting, determining your stake or bet size is a crucial factor. It enables you to decide the amount of money you want to allocate per point of movement in the market, which determines your potential gains or losses.
Your stake in spread betting is typically measured in pounds per point. For instance, if you place a £5 per point bet that the price of Apple shares will increase, you will earn £5 for every point that it rises. Conversely, for every point that it drops, you will lose £5.
There are two types of spread bets, depending on your desired position duration: Daily Funded Trades (DFTs) and Forwards.
DFTs have a far-off expiry date, allowing you to choose when to close your position. However, you'll need to pay overnight financing every day that you keep a DFT open.
Forwards have a fixed expiration date, which is typically at the end of the quarter, but you can close your trade any time before that as long as the market is open. You won't be charged overnight financing on a forward, but the spreads are wider instead.
Deciding whether to go long or short in spread betting
Spread betting differs from traditional share dealing because it allows you to sell a market when you anticipate that its value will decline, enabling you to profit from the falling price. This practice is referred to as 'going short,' which is the opposite of 'going long' or buying.
When opening a spread bet, two prices are displayed: the buy price and the sell price. Using this information, you can choose whether you want to go long or short. If you believe that the value of the market you have chosen will increase, you click buy. On the other hand, if you believe it will decrease, you click sell.
To close a spread bet, you need to trade in the opposite direction to when you opened it. Therefore, if you bought initially, you would sell to exit, and vice versa.
Example of spread betting: Buying Oil
Suppose you believe that the price of oil will increase; in that case, you may place a buy trade with a stake of £2 per point. This will result in a profit of £2 for every point that the oil price increases. However, if the oil price falls, you would experience a loss of £2 for every point that it moves downward.
Your profit or loss is determined when you close your position. For example, if the oil price increased by 50 points since you opened your trade, you would earn a profit of (50 points x £2) £100. Conversely, if the price of oil decreased by 50 points, you would incur a loss of £100.
Spread betting: Leverage and margin
Spread betting provides traders with leverage, which allows them to control a more substantial amount of money with a smaller investment. For instance, when spread betting on stocks, you may need to put up only 20% of the total value of your position, giving you a leverage factor of 5:1. Forex, on the other hand, can have a leverage of 20:1 or more. However, it's crucial to note that leverage magnifies both profits and losses, making careful risk management essential.
In terms of the margin in spread betting, this refers to the deposit that you need to maintain in your account to keep a leveraged trade open. With leverage, you must always ensure that you have sufficient margin in your account. For instance, if you want to place a spread bet of £10 per point on the FTSE 100 with a leverage factor of 20:1 when it is trading at 7,500, the total size of your position would be (10 x 7500) £75,000. Therefore, you would need to put up (5% of 75,000) £3,750 as margin and always have at least 5% of your position's total value in your account to keep it open.
Risk management in spread betting
It is very important to maintain good risk management when spread betting. It involves identifying potential risks associated with trading and developing a risk management plan to mitigate them for each position.
To control risk, stop losses are an essential tool. By placing a stop loss on an open position, you instruct your spread betting provider to automatically exit the trade if it moves against you by a certain amount. This limits your potential loss by setting a maximum amount you're willing to lose from a given position.
Benefits of spread betting
Spread betting is a favored product for traders due to its tax-efficient nature as there is no need to pay UK Stamp Duty or Capital Gains Tax (CGT). Additionally, spread bets are free from commission charges, and traders can leverage their trades with a relatively small deposit to control a larger value trade. Spread betting is flexible as traders can participate in both rising and falling markets by going long or short, respectively. Moreover, retail traders are protected against negative balances, ensuring that they cannot lose more than their initial deposit.