FxBrokerReviews.org – Spread betting is a derivative technique in which players don’t own the underlying asset, such as a stock or commodity, on which they bet. Instead, using the prices provided to them by a broker, spread bettors merely guess as to whether the asset’s price will increase or decrease.
For spread bets, two prices are given, much like in stock market trading: a price at which you may buy (bid price) and a price at which you can sell (ask price). The spread is the distinction between the buy price and the sale price. Contrary to the majority of securities deals, spread bets can be placed without paying fees because the spread-betting broker makes money from this spread.
Investors align with the bid price if they anticipate a market uptrend and go with the asking price if they anticipate a market downturn. Leverage, the opportunity to go long and short, the number of markets accessible, and tax advantages are some of the key features of spread betting.
Origins of spread betting
You wouldn’t be far off if you thought that spread betting was something you might do at a sports bar. The spread-betting idea is generally ascribed to Charles K. McNeil, a math instructor who moved to Chicago in the 1940s and eventually worked as a securities analyst and bookmaker. But around 30 years later, on the other side of the Atlantic, it began to develop as a career for traders in the financial sector. In 1974, Stuart Wheeler, an investment banker from the City of London, established IG Index, a company that offered spread betting on gold. Spread betting offered a simpler approach to speculate on the gold market at a time when it was prohibitively difficult for many to engage in it.
Stock trade vs Spread betting
Let’s use a real-world example to clarify the advantages and disadvantages of this derivatives market as well as the steps involved in placing a wager. We’ll use the stock market as an example first, and then we’ll look at a comparable spread bet.
Let’s say for the sake of our stock market transaction that we will pay £193.00 for 1,000 shares of Vodafone (LSE: VOD). The trade is closed with a gross profit of £2,000 and a profit of £2 per share on 1,000 shares when the price rises to £195.00. Here, take note of a few key aspects. This deal would have needed a substantial capital investment of £193k had the margin not been used. Additionally, commissions would often be assessed for entering and leaving a stock market deal. Finally, capital gains tax and stamp duty may be applied to the profit. Let’s take a look at a related spread bet now. We’ll suppose that if you want to spread a bet on Vodafone, you can buy the bet for £193.00 using the bid-offer spread. The next step in placing this spread bet is deciding how much to stake each “point,” the variable that represents the price change. A point’s worth can change.
In this instance, we’ll suppose that a change of one point in the share price of Vodaphone is equivalent to a change of one penny. Assuming a purchase or “up bet” is placed on Vodaphone at a price of £10 per point, we’ll move on. In line with the stock market example, the share price of Vodaphone increases from £193.00 to £195.00. In this case, the bet captured 200 points, meaning a profit of 200 x £10, or £2,000.
Although the total profit in both cases is £2,000, the spread bet is different since typically neither fees nor capital gains tax is payable when the bet is opened or closed. inside the UK. Spread betting profits are tax-free in the United Kingdom, as well as certain other European nations.
Also read: Best Spread Betting Platforms For Beginners
The bid-offer spread, which may be far greater than the spread in other markets, might hurt spread bettors even if they do not pay fees. Also, keep in mind that the spread must be overcome by the bettor in order to break even on a transaction. Usually, the spread is narrower and the entry cost is lower for traded securities that are more widely known.
The capital needed for spread betting is far cheaper, which is another important benefit in addition to the lack of fees and taxes. A deposit of up to £193,000 could have been needed to start the stock market deal. The needed deposit amount varies when spread betting, however for the purposes of this example, we’ll assume a 5% deposit is necessary. In order to assume the same level of market exposure as in the stock market deal, a far lower £9,650 investment would have been needed.
Of course, leverage may be used both ways, and here is where spread betting becomes risky. Higher profits will be obtained when the market moves in your favour; but, bigger losses will be incurred as the market goes against you. On a very little deposit, you may quickly make a sizable sum of money, but you can also lose it just as quickly.
The bettor may eventually have been requested to increase the deposit or perhaps had the trade automatically closed out if the price of Vodaphone dropped in the scenario above. If they still think the price will eventually rise, stock market traders in this position have the benefit of being able to wait through a downward market movement.
Financial Spread Betting Examples
You may better grasp how to spread betting functions by looking at a few financial spread betting examples.
Financial spread bets come in a variety of forms, including daily funded, rolling daily, and futures, but every trader enters them with the same, unambiguous goal in mind: to earn money.
Your spread bet will be beneficial if the price of the asset you’re betting on rises above the spread price at which you joined the market, but it will lose money if the market price falls in the other direction, against your prediction.
With a stop-loss order, which will shut off your spread bet transaction if the market moves a certain amount against you, you may manage the risk level in a spread bet. With a limit order, you may close out your trade and lock in a profit if the price moves in your favour.
We’ll look at instances of both a long/buy spread bet trade and a short/sell spread bet transaction as one of the benefits of spread betting is that you can sell short – anticipating a fall in price – as easily as you can buy long – hoping for a price increase.
Margin and stake
With any spread bet you place, there are two factors you need to take into mind. The margin need comes first. Spread betting is a leveraged investment, so you don’t need to put up the whole value of the underlying securities you’re betting on to open a position.
Instead, you simply need a little amount of trading capital, such as a few per cent of the entire value of the underlying securities, to submit a margin deposit to place a spread bet.
The amount you wish to invest on your spread bet must also be determined. The quantity of the underlying asset you are trading and, thus, the margin needed for your spread bet depends on the size of your investment. Your stake amount will be multiplied by your spread bet trade’s profit or loss in points.
A spread bet example – buy trade
Let’s take a look at how a buy rolling daily spread bet on Vodafone’s stock price in the UK might operate.
You conclude the price will increase after doing your study. You open a deal ticket after logging onto your broker’s portal and selecting the market. The cost is between 137.05 and 137.22. If you were to execute the deal, you would purchase at the 137.22 asking price. The bid price—the lower price in the spread—must increase above 137.22 for your spread bet to be profitable.
A Vodafone share is really trading for roughly £1.37 on the exchange when you spread bet, and you should double-check the market information page to remind yourself that the deal per is 1 unit. Company shares, like Vodafone, are listed in pence when you spread bet.
You choose to invest £5 per point, which is the amount you will gain or lose for every change in the price of one cent.
The market information page also shows that the minimum margin is 20% of the notional amount of the deal. This is further supported by the trade ticket, which indicates that the projected margin is £137. To execute this deal, you must have sufficient cleared money deposited with the broker.
You make the deal and purchase £5 worth of Vodafone points at 137.22. The broker often sends you a confirmation that the deal has been placed nearly immediately.
Since the market didn’t move much that day and you hadn’t concluded the deal by the time it closed at 16.30 UK time, you’ll be charged for overnight financing at 10 p.m. that day. The next morning, you go back into your account and discover a 6 penny financing fee. The price has increased by mid-morning the next day, you have profited, and you choose to close the deal.
When you open a deal ticket, you can see that the price is between 141.69 and 141.91. You need to sell back £5 per point at the sell/bid price of 141.69 in order to close out your long position of £5 per point.
When you sell £5 per point of Vodafone at 141.69, the transaction is immediately verified, just like your starting order. You are now out of Vodafone positions, the broker will release your margin, and any profit (or loss) from the trade will be accessible in your account.
If the price had dropped while you were holding the position, on the other hand, you would have booked a loss using the same formula.
A spread bet example – selling short
You would want to place a spread bet selling short in order to profit from a reduction in price if you think the price of a security on which you want to spread the bet would fall.
Let’s think about a spread bet on a currency pair for our example of a short sale. The exchange rate between the British pound and the US dollar is GBP/USD, sometimes known as cable.
- Your price is between 1.23000 and 1.23008. This indicates that in the underlying spot FX market, £1 is equivalent to around $1.23.
- The bet per is 0.0001, therefore a shift from 1.23000 to 1.23010 is equivalent to moving one point.
- You choose to sell each point for £5. This indicates that the trade’s notional value would be £61,500. £5 times 12,300 points.
- £2,048 is needed as a deposit for the deal because the margin requirement is 3.33% (30:1 leverage).
These are the situations if you are short £5 per point GBP/USD at 1.23000 and the transaction moves 50 points in your favour (down) or 50 points against you (up).
If you issued a limit order to purchase and the spread your broker was offering dropped down to 1.22492-1.22500, the order would be filled and you would lock in a £250 profit on the transaction.
You do not want the price of the underlying security to rise if you are selling short with your spread bet. If the spread on the GBP/USD rate had increased to 1.23492-1.23500, you would have lost £250, or fifty points, multiplied by your $5 position. However, if you had initiated the trade with a stop-loss order at 1.23200, you could have reduced your loss too, say, £100. If you had done so, your trade would have been closed off as soon as the spread reached 1.23192-1.23200.
The tom-next rate, which is the difference between paying the interest charge on the long currency and getting the interest rate on the currency you are short when multiplied by your notional position, is levied if you hold a currency daily rolling spread bet overnight.
Managing Risk in Spread Betting
Despite the danger involved in using large leverage, spread betting provides useful tools to reduce losses.
- Standard stop-loss orders: Stop-loss orders minimise risk by immediately terminating a losing transaction when the market crosses a predetermined price level. When a normal stop-loss is used, the order will close out your transaction at the best price when the predetermined stop value is achieved. Especially when the market is volatile, it is likely that your trade will be closed out at a worse level than the stop trigger.
- Guaranteed stop-loss orders: Regardless of the underlying market circumstances, this type of stop-loss order promises to close your trade at the precise value you have chosen. However, there is a cost associated with this type of insurance. Your broker often charges more for guaranteed stop-loss orders.
Using arbitrage, or betting in two different directions at once, is another technique to reduce risk.
Spread Betting Arbitrage
When prices of similar financial instruments diverge between marketplaces or between organisations, arbitrage possibilities might result. As a result, the financial instrument can be simultaneously bought low and sold high. These market inefficiencies are exploited in an arbitrage transaction to generate risk-free gains.
Spread betting and other financial instruments have seen fewer prospects for arbitrage due to greater communication and universal access to information. Spread-betting arbitrage is still possible, though, if two businesses adopt different market views when determining their own spreads.
At the expense of the market maker, an arbitrageur bets on spreads from two different companies. When the top end of a spread offered by one company is below the bottom end of another’s spread, the arbitrageur profits from the gap between the two. Simply put, the trader buys low from one company and sells high in another. Whether the market increases or decreases do not dictate the amount of return.
It is possible to take advantage of disparities in interest rates, currencies, bonds, and stocks, among other instruments, through one of the many distinct kinds of arbitrage. Contrary to popular belief, there are hazards involved in the process of arbitrage, including counterparty, liquidity, and execution risks. Transactions that don’t go as planned might cost the arbitrageur a lot of money. Similar to counterparty risk, liquidity risk can originate from the markets or a business’s inability to complete a transaction.
With the introduction of electronic marketplaces, spread betting has effectively cut entry barriers and produced a huge and diverse alternative economy. Spread betting is continually becoming more sophisticated.
Particularly when two businesses provide different spreads on similar assets, arbitrage enables investors to profit from pricing differences between two marketplaces.
Spread betting continues to be plagued by the temptation and dangers of overleverage. Spread betting is an appealing prospect for speculators due to the minimum capital need, available risk control techniques, and tax advantages.