Spread betting is a speculative strategy in which participants make bets on the price movements of a security. At its most basic level, this kind of speculation involves placing wagers on the bid and ask prices provided by a spread-betting company. Because spread betting does not involve buying or selling the underlying asset, it is a type of financial derivatives trading.
The bid price is the highest amount a buyer is willing to pay to purchase a security. Alternatively, the ask is the lowest price a seller is willing to accept for the security being sold. The difference between the bid and the ask is the spread. Once the buyer and seller negotiate a price, the transaction takes place.
While a buyer and seller are looking to work out a price for the security so they can set up this transaction, the spread bettor is making a bet on whether the security's price will rise or fall after receiving the prices offered by a broker.
For example, an investor buys 500 shares of Apple Inc. common stock for £100 apiece. Apple Inc. releases some important news and its common stock surges £7 apiece. The investor then sell these shares for a gross profit of £3,500.
This example provides a gain, but it also comes at a cost. Buying and then selling the shares generate fees, and the gains produced could provide the investor with tax liability. Past that, an investor would need to have £50,000 to make the initial purchase.
Had the Apple stock sunk £7 a piece, the loss would be £3,500 in addition to the large capital investment and fees.
As an alternative example, investor spread bettor makes a spread bet on Apple Inc.'s common shares. He believes the company's stock will surpass £100, and a spread-betting company quotes a bid price of £100 and an offer price of £105. The investor wagers £10 for every 1 pence the price increases above £100. Should the stock reach £107, the bet captures 700 points, which would generate a profit of 700 x £5 or £3,500.
Had the market swung in the opposite direction, dropping 700 points at £5 a point, the spread bettor would see a £3,500 loss, equivalent to the stock trader's loss. In this case, however, the large capital investment is lessened because of the available leverage.
Trading on margin carries a high degree of risk and losses can exceed deposited funds.
If the investor decided upon the spread-betting approach, he would gain or lose the exact same amount as he would have made by buying the shares outright and then selling them. However, spread betting would not require the investor to have £50,000 in capital. In addition, using this approach would likely allow him to avoid paying capital gains tax or commissions.
While there are many speculative activities investors can harness, spread betting sets itself apart in certain ways. Those interested in spread betting can potentially enjoy tax benefits through such activity in some jurisdictions, primarily the United Kingdom or Ireland.
Spread bettors can initiate both long and short positions, while investors who purchase stock outright are relying on the shares rising in value to capture capital appreciation. By taking part in spread betting, investors can make use of leverage, which could amplify both gains and losses. Finally, spread bettors can make relevant wagers in a wide range of markets.
Investors should keep in mind that spread betting comes with risks of its own. If they participate in such activity, they will have to worry about the bid-offer spread, which could be greater than the spreads of other markets.
Additionally, spreads become increasingly narrow as the asset they involve becomes less thinly traded, and the bettor must overcome the spread to simply break even on a trade.
While leverage can potentially increase returns, it can also amplify losses. As a result, investors using this resource could lose substantial amounts in a short time frame.
There are some simple approaches investors can use to help manage the risk associated with spread betting.
Stop Loss Orders - Investors can help limit their risk by using a stop-loss order, which automatically closes out a trade once a market price rises or falls below a certain level. Spread bettors could potentially set up guaranteed stop-loss orders, which will close a position out at a specified amount; or a standard stop-loss order, which will close out a trade at the best available price once a stop value has been hit.
While a guaranteed stop loss provides greater certainty, the associated broker may levy an additional fee. Alternatively, a standard stop-loss order can cause a position to close out at a point that is even less advantageous than the stop point.
While some use spread betting as a means of generating a profit through placing wagers on a security's future price movements, spread betting on margin involves a high level of risk and losses can exceed deposited funds. Interested investors should conduct the needed due diligence and/or consult an independent investment adviser.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…