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. Participants are able to target a vast array of products, including shares, equities indices, forex pairs, commodities and bonds.
Basics Of Spread Betting
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.
Origins Of Spread Betting
Spread betting was conceived by mathematics instructor, securities analyst and bookmaker Charles K. McNeil in the 1940s. McNeil is credited with being the creator of the "point spread," a device that assigns a tangible score differential between the favourite and underdog in a contest. The point spread is intended to level the playing field, as bettors are able to wager on a contest's outcome in a binary fashion. This is possible by wagering that the point spread will be covered by the favourite or that it won't.
McNeil's innovations greatly simplified sports betting, which had previously relied on an odds primer known as the moneyline to settle sportsbook wagers. As the point spread became the sports betting industry standard, many of its principles were deemed applicable to the capital markets. During the mid-1970s, spread betting entered the world's financial markets through the launch of the Investors' Gold Index (London, U.K.). In the decades that followed, spread betting products expanded into the forex, commodities, shares and indices asset classes.
Spread Betting Example
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 sells these shares for a gross profit of £3,500.
The above 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.
Arbitrage is a trading strategy where a trader or investor buys a security in one market while simultaneously selling the same security in another. In doing so, arbitrageurs are able to profit from pricing inefficiencies virtually risk-free as the open positions are conflicting, or "covered." Although arbitrage opportunities are considered to be rare in the financial markets, lucrative situations do exist.
Theoretically, arbitrage strategies yield zero returns in a truly efficient market. However, forex traders from legendary economist John Maynard Keynes to contemporary high frequency trading (HFT) firms have profited from such strategies. Below are two of the most commonly executed forms of forex arbitrage:
In this type of arbitrage, a trader capitalises on exchange rate discrepancies between liquidity providers. This is done by physically purchasing a currency from one provider and exchanging it for another with a second provider. By doing so, the trader may profit from a beneficial difference in the bid/ask spreads offered by each of the providers.
Triangular arbitrageurs aim to profit from small forex exchange rate inefficiencies between three currencies and liquidity providers. To execute such a strategy, one makes an initial currency exchange, a second exchange, and then a third exchange back to the base currency. An example of a triangular arbitrage would be to trade euros for British pounds, British pounds for U.S. dollars and U.S. dollars back to euros.
Arbitrageurs are subject to a collection of strategic advantages and disadvantages. On the upside, arbitrage strategies are extremely low-risk and require minimal capital outlays to execute. Conversely, positive expectation setups are difficult to find in the financial markets and have extremely short shelf lives. So, while the risk-free returns of arbitrage are certainly attractive, sustaining profitability over the long-run is a challenge.
Potential Drawbacks Of Spread Betting
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.
Aside from disciplined trading habits and prudent money management principles, stop loss orders are powerful tools for managing spread betting risk exposure. Stop losses limit risk as they automatically close out a trade once market price rises or falls below a certain level. For spread bettors, stop losses come in two order types: stop limit and stop market.
A stop market order rests below a long position (sell stop market) or above a short position (buy stop market) at a specified price point. When the market touches this price point, the open position is immediately liquidated at the best available price. With the stop market order, the trade is guaranteed to be closed out when the desired price point is hit. Due to its functionality, the stop market order is known as the guaranteed stop loss. In some cases, the associated broker may levy an additional fee for its application.
Like the stop market, the stop limit order rests at the market below an active long position (sell stop limit) or below an active short (buy stop limit) at a specific price point. However, the stop limit requires that the order is filled at the designated price. Known as the standard stop loss order, stop limits may go unfilled or cause a position to close at a point less advantageous than the original stop location.
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.
Important Information: FXCM offers spread betting exclusively to UK residents. Residents of other countries are NOT eligible. Spread betting is not intended for distribution to, or use by any person in any country and jurisdiction where such distribution or use would be contrary to local law or regulation.
Please note that all screenshots and illustrations are only shown for demonstration purpose and should not in any way be construed as recommending any type of trading strategy and they do not constitute any form of investment advice.
This article was last updated on 6th August 2021.
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…