In simple terms, spread betting in financial trading allows you to speculate whether a price will go up or down, and to set a defined amount to win or lose for each unit of change.
Spread betting in Forex allows you to speculate on the price movements of currency pairs. In this form of trading, you trade on whether you believe the price of a currency pair, such as EUR/USD or GBP/USD, will rise or fall and your unit would be the ‘pip’. If you were to hypothetically trade £1 per pip going long, a 20 pip movement in your favour would equate to £20 profit. On the flip side, a move in the opposite direction would trigger an equal loss.
Spread betting on stocks works similarly to spread betting in forex, but instead of speculating on the price movement of currency pairs, you are betting on the price fluctuations of individual company shares. The same rules apply to indices, commodities, and other instruments supported by the various brokers.
The term “spread bet” is a widely used terminology and simply refers to the act of placing a wager on the potential outcome or result of an underlying action, where the payout is based on the accuracy and proximity of the outcome. This eliminates the usual win or lose structure where a finite amount is placed on a trade on the outset.
The Benefits of Learning How to Spread Bet
- Holding long and short positions
- Tax efficiency and benefits
- No commissions imposed
Spread betting offers several benefits. It provides an easy way to speculate on both rising and falling markets. In the case of stocks, if you believe the company’s share price will fall, you can go short and profit if the price drops. This is often easier and less restricted than traditional short selling.
Additionally, no ownership of the actual stock means there’s no need to pay for the full value of the shares, and you avoid issues such as stamp duty in the UK, which is usually applicable in regular stock purchases. Spread betting is also tax-efficient where profits are often free from capital gains tax.
When spread betting, you also needn’t worry about commissions. This is because spread betting brokers make their profit from the spread prices they offer. This is a strong plus if you are looking to avoid unexpected, or high trading costs.
Exploring the Mechanics of Spread Betting
Spread Bet Example:
- Choosing a Instrument: You select the currency pair, stock, or index, you want to bet on, such as EUR/USD, Apple, S&P 500, etc.
- Pay Attention To The ‘Spread‘: The broker will quote two prices — a bid (the price you can sell) and an ask (the price you can buy).
- Placing Your Trade: You place a bet per point (pip) movement in the currency pair. For example, if you bet £1 per pip, and the market moves 10 pips in your favour, your profit will be £10.
– If you believe the currency will rise, you would go long (buy).
– If you believe the currency will fall, you would go short (sell). - Profit or Loss: Your P/L is determined by the size of your bet per point and the number of points (pips) the market moves relative to the direction of your bet.
The idea behind spread betting is not for traders to stray away from owning specific underlying financial market instruments, but rather entering into contracts and forward positions that allow you to take advantage of the price changes of the asset over a period of time. Many use spread betting as a hedge against long-term positions, but others simply to conduct a ‘trade’ rather than make an investment.
The fact that spread betting allows you to enter into two different market positions (long or short) can prove to be a good thing, however, caution and prior understanding is necessary to avoid being another loss percentage statistic.
At its core, the act of spreading a bet involves taking a position (sometimes multiple positions) based on how you think the instrument will perform in the future and is commonly used by those with short term strategies such as scalping, or swing trading.
When taking a position, there are two factors to note: the ‘bid’ and the ‘ask‘. The bid is the price at which you can buy the asset, and the ask is the price at which you can sell the asset.
Between these two potential positions is what is known as the spread. Thus, you are speculating whether the price or value of the underlying asset will be higher than the ask or lower than the bid.
Speculation in financial markets is not intended to be conducted on a whim or gut feeling (although this has worked for some). It should be based on a combination of fundamental, or technical analysis, and with a pre-defined trading strategy and plan that includes targets for entry, exit, stop losses, and take profit.
Spread betting also uses leverage, which will amplify your results in either direction. This is neither a benefit, nor a negative if used correctly, but in the wrong hands, leverage can easily see an account blow up. Leverage remains one of the major risks in spread betting, as it can magnify losses as much as it can amplify gains.
In the instance of the UK regulator, the FCA, leverage on forex is capped to a maximum of 1:30 for major pairs, whereas stocks are limited to 1:5. These are protection measures aimed to help users manage the risk appropriately and vary by instrument.
The Limitations of Spread Betting
Whilst we saw some potential benefits to learning how to spread bet, the actual act of trading does have some disadvantages to consider.
- Margin calls on accounts
- Wide spreads
- High trading costs
As you do not pay the full value of your position, the percentage which is outstanding is referred to as the margin. Spread accounts also have margin requirements (essentially the percentage of funds that always need to be present in the trader’s account). If, or when the funds in the account fall below the required margin, you will receive a margin call. Depending on how you have been using the funds in your account, a margin call can be especially high.
It is also important to monitor the instrument you are considering trading for having a potentially “wide spread”.
This often occurs during periods of volatility, which results in brokerages tightening their belts and widening their quoted spreads. A wide spread can also trigger stop losses, in turn triggering higher trading costs. Some of the most volatile periods for stocks would be in the lead up to earnings reports or any other announcements that may affect the stability of the stock or asset so it would be prudent to be especially careful around these times.
How to Manage Risks Associated With Spread Bets
The fact that spread betting uses leverage as its basis of profit making presents you with certain risks to hedge against. Taking a market position and investing in that position, no matter how small the investment is, poses certain risks, especially if you are misinformed about how the market will actually perform. Therefore, it is important to know and understand your intended trading market fully. This includes any underlying volatility and how the entire structure moves.
Despite all these risk, traders learning how to spread bet have ample tools available that they can employ to shield themselves from losses associated with risks. Deployment or utilisation of these tools ensures that emotional spread betting is replaced by logical and strategic methods. Without this knowledge, chances of success can easily diminish as opportunities are lost due to lack of skilful application of the trading tool.
These tools come in the form of stop loss orders. The first stop loss you can use is the standard stop loss. This reduces risks by spontaneously closing out the trader’s position once the market exceeds a set price. The loss will close out your position for the best possible price available in the market at the time. The second stop loss order option is the guaranteed stop loss. This works in the same way as the standard stop loss, however, this one only closes your position at the exact value you have set it to, making it a guaranteed stop on your position.
How to Create Arbitrage Through Spread Betting
One of the most beneficial aspects of spread betting is the fact that it is a vehicle of risk hedging.
Spread bets can be used on any number of assets, which allows this form in trading strategies to be the perfect tool for portfolio diversification. You can take multiple positions at any term in any location on any instrument to hedge against volatile market prices and changes.
This can create portfolio arbitrage for a number of investors and traders.
An arbitrage is an opportunity that arises when the price of identical instruments varies from one market to the next among separate companies. This overview allows you to access which instrument is most likely to be viable, though further analysis is required and deemed essential. This creates a gap, where the asset can be bought in one location at a lower price and sold in another at a higher price.
Creating spread betting arbitrage occurs when investors are equipped with the knowledge and information to exploit these market efficiencies. However, this same knowledge and information limits arbitrage opportunities from lasting too long, and since this information is spread across markets, as each market adjusts the arbitrage is lost.
Spread betting arbitrage can still, however, be sustained, even when the market adjusts. To achieve this, the arbitrageur spread bets on two separate companies. Whenever a top-end spread that one company is giving goes below the offering of the second company, an arbitrage gap is created.
