Clicky

What is Financial Spread Betting?

Posted By Andy On Saturday, November 2nd, 2013 With 0 Comments

Spread betting (sometimes referred to as spread trading) is a way of trading the financial markets without ever having to purchase stocks or shares.

Traditional investment in shares involved calling up your stock broker or opening up an online share dealing account and buying x number of shares at a certain price. You owned these shares personally and you held them until such time as you were ready to sell them (hopefully at a higher price than you bought them at). You paid the broker who you bought the shares through a commission, assuming you sold the shares for a higher price then you bought them you paid capital gains tax (currently 25%) on any profits you made. Owning the shares also entitled you to a dividend for every share you owned (assuming the company you bought the shares in was in a position to pay a dividend) and you were also entitled to attend and vote at the company’s AGM.

Spread betting on the other hand works differently. Firstly, you never actually take ownership of the shares you open a trade on. Instead you effectively open a bet on the future movement of the stock in question. This allows you go either go long (bet that the share price will go up) or go short (bet that the share price will go down) when you open a spread trade. There are many benefits to spread trading but this is probably one of the most useful, the idea that you can bet on shares going down. In midst of todays global financial crisis, the option to bet on share prices falling and make money if that turns out to be the case is a huge advantage.

A spread bet is as such a contract that is made between a spread betting provider and you, the buyer or seller of the contract. It simply involves speculating on the direction of price fluctuations.  Whether you are speculating or hedging, spread betting is a tax-free and a cost effective way of gaining entry to the financial markets. It is a derivative product traded on margin and based on an underlying market.

The Key Concept

In a nutshell, spread betting means that using a small amount of your capital, you can profit from up and down moves in the financial markets.

It is a way of trading the stock markets without actually owning any shares or assets and you simply speculate on the ‘price movement’ of a share, index, commodity, currency or a bond.

If you believe from your analysis that a particular market is going to rise, then you would place a bet of your chosen amount on that market in the expectation of a move higher than your opening price. If your analysis proves to be correct you make a profit and if wrong than a loss would be incurred.

You can actually make money from both rising and falling markets using spread betting. More details of this concept will be covered during this course.

Any profits you incur are tax free. But also remember that any losses you incur are not tax deductible.

Spread Betting Explained

A question I have been asked many times by friends and family is what exactly is spread betting.

My simple answer is, well you know if you buy a stock and it goes up then you sell it you earn money. Well spread betting allows you to benefit by that move without actually buying the stock and as such avoid the implications of tax (both stamp duty and income tax), tying up large amounts of your capital and broker commissions.

Spread betting allows you to take a position, on whatever you think any financial instrument will do next. The more that market moves in your favour, the more you profit, with unlimited potential. Unfortunately, the more the market moves against you, the more you could lose – and you may lose more than your initial deposit.

When you open a spread trade you need to decide whether you are going to Buy (go Long) or Sell (go Short). You then need to decide what stake per tick (or point) movement you are going to put on. A tick or point is the smallest amount that the price of a share can move by, typically the equivalent of a one cent (or one pence) movement in the share price. So for example, if CRH was trading at €17.00, that would translate to a price of 1700 on a spread trading website. If the share price moved up to €17.50, that would equate to 1750, or a 50 tick movement.

If you were long on CRH at a stake of €2 a tick, you would be up €100 following that 50 tick movement. If on the other hand you went short CRH at 1700 at a stake of €2 a tick, you were hoping the share price would fall, in the case where it rose to 1750 you would now be down €100.

As such you place an amount of money on each point that the market moves.

For instance if you bet that BP will go up at £10 a point and it subsequently goes up 50p you win 50x£10 = £500

HOWEVER

As in all markets (and I use the terms markets in a sense that it could be a stock, an indices, a forex pair etc) if you have not called the move correctly you will lose. In the example above if BP went down 50p then you would lose £500.

A point is normally in 1p movements in the larger UK stocks and in cents on the US stocks. So BP @ £5.00 a share is 500 points.

The Mechanics of Financial Spread Betting

As mentioned, spread betting allows a trader to open a position without owning the underlying asset. Essentially, what happens is that a trader places a “bet”, assigning any value he chooses to a price point, on which direction the price will move.

So, for example, if a trader feels that the price of gold will drop, he can place a “down” or “sell” bet and his profit will be equivalent to the number of price points the commodity drops multiplied by his bet. Thus, if his bet is £10 per point and gold drops 50 points then his profit would be equivalent to £500. Of course, the potential for loss is just as great, so if the price moves against the trader then he stands to lose £500 or even more, until he closes his position.

Generally, though, traders protect themselves by informing the broker of the maximum amount of funds they are willing to risk and by placing a stop-loss. This will ensure that their loss is never greater than the amount of money they are willing to lose.

If the trader, on the other hand, feels the price will rise, then he would place an “up” or “buy” bet. The mechanics are the same, though, for any underlying asset and any direction one trades in.

Spread Betting and Margin Requirements

Even though financial spread betting means that you will never own the underlying asset, you will still need to have sufficient funds to cover any losses you may incur. This is usually referred to as the Notional Trading Requirement (NTR).

The NTR is calculated in two ways, either as a percentage of the maximum potential loss you may incur, usually 10%, or as a bet size factor, which is a multiple of a preset value. The latter differs from broker to broker and can also differ depending on the financial instrument you want to bet on.

While spread betting may not be the classic definition of gambling since traders place bets after doing intensive technical and fundamental analysis, it still carries a significant level of risk. Therefore, a good rule of thumb is never to trade or bet with money you can’t afford to lose.

On the other hand, spread betting is one of the easiest derivatives to understand and its simplicity is what attracts many traders. It is also one of the few ways retail traders can profit from large market volatility without needing to make a large investment in the underlying asset.

What spread betting is not

Betting on the spread. It is a common misconception that spreadbetting is to do with betting on the spread of a stock (the difference between the buy and sell price). It is not, you make or lose money on the price movement. The only reference to the spread that you need to think about is that is where the spreadbetting companies (like Ayondo) make their money. The spreads in spreadbetting are larger than if you were actually buying and selling a stock (they have to make their commission somewhere).

It is also a misconception that spread betting companies set the size of the spread. In truth the spread is normally determined by marketmakers in the market you betting on, the betting company just adds a few more points each side to get paid.

Understanding the Bid & Offer Spread

So we have discussed going Long or Short and the stake per tick, next up is the spread (what gives Spread Trading or Spread Betting it’s name). The spread is effectively the difference between the price you can go Long at and the price you can go Short at. It is always where the various spread trading companies make their profit. So if we were to go back to our earlier CRH example and make it a bit more accurate, if you wanted to trade CRH and it had a current share price of €17.00, then you could either go long at a price or 1710 or go short at a price of 1690. This 20 tick difference is what the spread trading company makes on your trade. So if you went long at 1710 at €2 a tick, you would immediately be down €40 (20 ticks x €2 per tick). You would need the CRH share price to rise 20 cent (to €17.20) to breakeven at which point the price offered by the spread trading company would be go long at 1730 and go short at 1710. For every cent that the CRH share price continues to rise, you would then be up €2. So if the share price continued to rise up to lets say €18.00, the spread would then be go long at 1810 and short at 1790. At this point you could close out your Long position in CRH. To do this you effectively sell (or go Short) CRH to close your position. So you would close your position by selling CRH at 1790. The difference between your closing price (1790) and your opening price (1710) is 80 ticks. At your initial stake of €2 per tick you would have made a profit of €160.

As always with spread trading the reverse is always true, lets say you went long at 1710 but instead of going up the CRH share price fell to $16.00. The spread would then be long at 1610 and short at 1590. In this case to close your position out you would need to sell CRH at 1590. The difference between your closing price (1590) and your opening price (1710) is 120 ticks. At your initial stake of €2 per tick you would have made a loss of €200 (Note: €40 of this was the initial spread).

Spread betting can be thought of as a two way price.

Let’s say for example that you are traveling to a foreign destination and require some money to be exchanged at the airport.

The cashier will quote you a price for the currency as follows:

150 – 155

The price on the Left side is referred to as the ‘BID’ or ‘SELL’ price and the one on the Right is referred to as the ‘OFFER’ or ‘BUY’ price.

In this example you are being offered a price of 155 to BUY.

If you buy and decide for any reason to sell the currency back then they will only pay you the bid price. In this example you purchased at 155 and returned the currency back at 150.

The difference between the bid and the offer or in other words the sell or buy is called the ‘SPREAD’.

Bid-Offer Spread

It is important to know that in fast moving markets, prices can move rapidly whereby the bid and offer can change in seconds. In some cases the spread can also widen in uncertain markets or due to an unseen force outside of the markets.

Therefore you could potentially profit or lose money very quickly. Hence the requirement to understand the markets fully is essential.

The LONG and SHORT of Spread Betting

Some people new to spread betting can become confused with the terminology used by traders. Like with anything else, in a matter of time and with practice you can become quite proficient with the language used.

Let’s say you think the price of a particular market in question will go up then you ‘BUY’. In market terminology we can say that you are ‘LONG’ the market.

Likewise, if you think the price will fall, you ‘SELL’ and we can say that you are ‘SHORT’ of the market.

Remember you do not necessarily own the physical instrument, you are simply backing your trading judgment and speculating on the price movements only.

So if you are Bullish and you think the market will rally by rising up – you open a LONG position.

If you are Bearish and you think the market will fall – you open a SHORT position.

To help explain further lets now look at a worked example

Note: Most of the examples mentioned here relate to shares but it is worth noting you can also spread trade all the major indices (DOW, DAX, FTSE, ISEQ, etc), currencies (EUR, USD, GBP, etc), commodities (e.g. gold, silver, oil, wheat, etc), bonds and interest rates.

Share Button

Leave a comment