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Is spread betting bad?

Posted By Robert On Saturday, December 21st, 2013 With 0 Comments

Spread Betting – Dispelling the Myths

A lot of financial traders are put off by spread betting purely because it has the word ‘betting’ in the title. They associate the word betting with gambling and any financial trader is not a gambler. They take calculated risks which is certainly not gambling. Well you know what, sugar coat it as much as you want but if you trade the financial markets via shares, CFDs, ETFs, options or any other financial instrument, like it or not you are indeed gambling. Ok so you may have a strategy that gives you an edge over the 50:50 win lose odds that you would have should you just trade randomly. But like it or not there is no way that you can predict with 100% accuracy the direction or depth in which a particular market or stock will move. Anyone that tells you that they have a 100% guaranteed system is a bare faced liar. There is no such thing nor will there ever be one. The holy grail spread betting strategy does not exist fact.

People in general don’t hate spread betting as a trading instrument, the knowledgeable ones will appreciate that this trading medium is simply a way to extract money from the stock market tax free. What they despise is that spread betting providers take the other side of trades and irrespective how much they complain and whine, they can’t accept the fact that it is not the providers’ fault at all but the way they are trading which is self-harming them; by utilizing too much leverage or overtrading or setting stops too tight, doubling up..etc The top spread betting providers invest substantial amounts of monies in research and development and all they have to do is wait there patiently because they know that most traders will end up losers, and fairly quickly for that matter! The providers don’t have to do anything, human nature is what it is and doesn’t help traders at all.

The thing is there is absolutely no reason to be put off by the word ‘betting’ in the term financial spread betting. There is no reason that you cannot use financial spread betting as part of a well though out investment strategy. In fact the use of a spread betting account in any good trading strategy is a very wise move. Spread Betting is currently free from any form of Tax in the UK and therefore you get to keep every penny of any profit you make. The only charges that are involved are those in the slightly larger spread and the cost of rolling charges if you take out a rolling daily bet. It depends on your bet size but of your keeping it small it’s actually cheaper than trading via a regular stock broker. The extra spread and rolling charges are how the spread betting companies make most of their revenue, but hey they have to turn a profit or we won’t be able to trade with them.

It’s also widely believed that spread betting firms want you to lose as this is part of how they make their money. While there may be some truth in the fact that sometimes when you lose they make money they majority of their revenue is from the spread and rolling charges. I suspect that when you place a trade, a professional trader will take a view as to whether to place the trade on the open market as well. If they think it’s a good trade and there’s a chance you will win they may place the trade on the open market to hedge your position. If they think it has a chance of losing they may take the view to not hedge the trade with the view that they will profit from your loss. Of course when the spread betting firm does this they take a risk as the position could easily turn into a profit and they have to pay you what you are owed from their own pocket.

Is spread betting risky?  Here’s what Paul Scott, an experienced small caps fund manager had to tell us -:

It is a leveraged trading product but this doesn’t mean that it has to be high risk.  And there is no reason why it shouldn’t be considered as something different from buying into physical shares – the risk/reward works in much the same way.  The problem with most traders is that that they tend to abuse the leverage.   Let’s suppose that you deposit 10k into a spread betting account; this will permit you to open geared positions in any stock.  Some traders (particularly the inexperienced ones) tend to open bets with a market value of £50k using this equity which essentially means that you are using 5 times gearing, on 20% margin.

What next?  As soon as there is a market retracements your losses are multiplied by 5 times and you are suddenly faced with crippling losses, and your trades are either cut back on panic or closed out by the spread betting company if you are faced with a margin call.  And then you end up leaving with maybe half your 10k account wiped out, if the stocks you are holding pullback by a modest 10%.

But it doesn’t have to be this way.  If you use sensible leverage of say, 1.5 x equity, then your capital will be restricted to £15k underlying positions.  This will allow you to survive market downswings including the prolonged ones without facing margin calls.

Another good idea is to make use of gearing counter-cyclically.  This means that you should avoid getting involved in a market that is getting way too expensive or even reduce positions in such a scenario.  Sit on the cash and wait for a market reversal.  Only buy when the shares are cheap or close to bottoming out and then build up some conservatively geared trades which will amplify the gains as the market recovers.  Of course, with the markets timing is very important so if in doubt avoid using gearing.

The other reason people fail at spread trading is because of the flashing lights and whistles that are often present on trading platforms which can easily get you to deal in markets which you don’t understand.  So you might start out with a simple strategy like a short trade on an index to hedge your shares portfolio but end up randomly punting on unfamiliar areas.  I’ve been guilty of this myself and can be catastrophic particularly if you start chasing losses on the Dow, Gold, forex pairs, whatever you’ve got sucked into punting.

So my advice is not to do this! Don’t spread bet on unfamiliar markets unless you have an advantage in terms of experience/expertise & track record on that asset class.  So I tend to do well in small caps, as I’ve been a professional small caps Value/GARP investor for the last 11 years. Hence these days I restrict my spread bets to just small caps, and I only use a modest amount of gearing – except when I find something amazingly cheap, and then I will push the boat out and gear up some more, but only after having researched it so carefully that I’m 100% sure I’m right.

The other thing is to consider the type of company you are spread betting on. If it has net debt, then there is a risk of a discounted rights issue or Placing, both of which can seriously clobber the share price. That is a disaster for people who have spread bets on that stock. Take First Group (FGP), a large cap that had a stretched Balance Sheet, so they raised about £600m in a deeply discounted Rights Issue. The share price had been about 220p beforehand, and the Rights Issue was priced at 85p for a 3 for 2 issue. This killed the share price, which fell to below 100p. Imagine if you had geared up on this share via a Spread Bet?

IG Index allow you to gear up to 10 times on FGP, so if you had £10k in an IG account, and you had maxed it with FGP shares, at 220p, that would mean you could have up to £100k underlying position value, so that would have been an opening bet of £455 per point at 220 opening price.

When the Rights Issue was announced on 20 May 2013, your account would have been wiped out (assuming you hadn’t used a guaranteed stop loss), with the share price falling almost 70p, and it carried on falling to under 100p by Jun 13th. So say you got closed out at 150p, that would have incurred a loss of 70 points * £455 = £31,850, on a £10,000 account – which potentially (depending on when they closed the position) the SB company coming after you for the balance of £21,850 not covered by your initial £10,000 deposit. As they say in their risk warnings, losses can exceed the initial deposit, so it’s dangerous stuff.

This shows the dangers of excessive gearing. It also shows the danger of lack of diversification.

In my experience spread betting is only safe if;

  1. You stick to an area of investment that you know well, and have a competitive advantage in, and consistently made money in. Avoid everything else.
  2. You strictly control your gearing, keeping it below 2 times always, and much lower than that in times of market frothiness (e.g. now). You don’t have to use any gearing at all! Remember the old adage, “Gear today, gone tomorrow!”
  3. You diversify your positions, so that no single stock could do any major damage to your account. I have found this means no more than about 15-20% in any one stock.
  4. You only spread bet on safe stocks – i.e. companies with net cash, which pay a decent dividend, and have a strong balance sheet.

Spread betting is not compatible with small, speculative stocks. Yet that is exactly what many punters use it for – which combined with gearing, is a disaster waiting to happen, when inevitable these stocks plummet once the market realises they’re all hype and no substance

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