Guide to Spread Betting
Spread betting is simply a form of gambling on the future movement –whether up or down - in shares, bonds, commodities, property, or any other asset class you wish to bet on. And today’s see-sawing markets are providing fertile ground for spread betters. For the speculator, sharp swings can provide an ideal opportunity for a spread bet.
For the investor wishing to hedge risk, spread betting is a convenient way of ‘shorting’ individual shares or indices. Get it wrong, however, and the potential for losses is unlimited, because when a market turns suddenly, you can easily get caught out and lose your shirt. Despite this, stockbrokers report a large increase in the number of spread betters since the credit crunch started in August 2007. If these people can bet correctly on the direction a stock or index is heading in, they can reap instant benefits. Get it wrong, and the losses can be huge, so spread betting is not for the faint hearted.
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When you place a spread bet, you will be quoted two prices: a bid and an offer price. The gap between the two is known as the ‘spread.’ Here is an example of how it might work. Suppose, you chose to bet on the FTSE 100, which, for the sake of this example stands at 6,000. You may be quoted a spread of 5,995 - 6,005. So what happens next? Well, there are four possibilities:
You believe the FTSE will rise further and make your bet, at say, £5 a point, and you wait. You are in luck, and the FTSE rises 100 points. When you decide to cash in your bet, the spread betting firm is offering a spread of say 6,095 – 6,105. This means you make money on the difference between the upper spread price when you made the bet, and the lower spread bet at the time of sale. In this case, that's a difference of 6,095 minus 6,005. That's 90 points. As your bet was for £5 a point, you make £450.
If on the other hand, the FTSE 100 falls 100 points, when eventually you cash in your bet, the spread range might be say 5,895-5,905. Then you will lose the difference between 6005 and 5895. That's 110 points. You have lost £550. The second two possibilities relate to the pessimist as well.
Assume you are a pessimist, and you bet, say £5 a point that the FSTE 100 will fall. Suppose you get it right, and the prices described in the second scenario above apply. That means the spread range drops from 5,995 – 6,005 to 5,895 – 5,905. You will benefit from the difference between the lower price of the spread when you made the bet and the upper price of the spread when you cashed in. That works out as the difference between 5,995 and 5,905. That's 90 points, at £5 a point, so you’ve made £450.
And finally, through your half empty glass you predict a fall in the FTSE, but get it wrong. The spread price jumps from 5,995-6,005 at the time of sale to 6,095- 6,105. You lose the difference between 5995 and 6105, that's 110 points. You lose £550.
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When you bet on a move upwards, you buy at the upper end of the spread and sell at the lower end.
When you bet on a downward movement, you buy at the lower end of the spread, and sell at the upper end.
The spread is the way in which the spread betting firm makes it’s money.
When making a spread bet, you will frequently be offered a ‘guaranteed stop loss.’ They say that the potential loss from spread betting is unlimited, but actually, that's not quite true. Since shares cannot fall below zero, there is, in fact, a limit to your potential loss. In the worst possible scenario, the FTSE could crash all the way down to nothing, in which case, (using the example above), you will have lost £5 times 6,000 points or £30,000.
In practice, of course, if the FTSE did fall that far, then a disaster must have occurred which would have made your petty worries over your spread bet look trivial. But we all know markets can crash, wiping hundreds of points off any market index in a day. For example, in the 2000-2003 bear market, the FTSE 100 nearly halved in value. That's why a guaranteed stop loss is considered essential. It means that you are protected if the index you are betting on falls below a certain level, thus limiting your maximum possible loss. It is tempting to say that in spread betting the odds are stacked in favour of winning.
After all, the potential upside is unlimited, but the potential loss is limited by your guaranteed stop loss limit. But for the regular spread better, this relationship bias tends to lessen. There is one more important point relating to guaranteed stop losses. Once you investigate spread betting further, you will notice that this form of investing, or if you prefer, gambling, typically applies only to indices, commodities and very large companies. Why is this? Part of the reason lies in guaranteed stop losses. It’s quite simply impossible to obtain this protection for a small company where the shares are potentially very illiquid.
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There are many advantages and disadvantages to spread betting, and we shall come to these in a moment. But, it is impossible to look at this without drawing your attention to its tax-free status. Any gain you make from spread betting is free of capital gains tax, just like a bet on the horses. Neither do you have to pay stamp duty on your purchases.
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Cast your mind back to the late 1990s. Dotcoms were rocketing, but many investors worried whether it could last. For some investors, the lure of potential gains was too much. They didn't want to miss the boat, while less risk averse fellow investors raked in the profits. If you were one of these worried investors, you could have wagered against your own portfolio. In the event that shares stopped their steady climb and began to fall, then your spread bet would at least compensate you for some of your losses. But, there is a better example. Suppose you hold shares in a company, and you strongly believe they will continue to rise, but you are worried about the capital gains tax liability.
Mitigating your CGT liability
Time was when you could avoid this through a practice known as ‘bed and breakfasting.’ You sold your shares on the last day of the tax year, and bought them back again the next day. But the chancellor outlawed this practice, and now there has to be 30 days between selling shares and buying them back again, before you can make use of your capital gains tax allowance. In fact, so long is this time lag that investors trying to reduce their CGT liability in this way, must fear that during the 30 day interval, share prices might have rocketed in value. After all, you expect the share to grow in price eventually as this is the very rationale for holding the stock in the first place.
Suppose you bet on your shares moving up in price. If this does indeed happen, then you are quids in, and because of the tax-free status of spread betting, there's no tax to pay. On the other hand, if the shares fall in price, you lose your bet, but because you were planning to buy these shares again anyway, you can jump back in and buy them at a cheaper price. The money you lose from the spread bet will be roughly similar to the amount you gain by being able to buy the stock back for less money. So in this case, by taking out a spread bet, you have reduced your risk.
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Before embarking on spread betting, be sure to understand the risks involved. Don't get sucked into spiraling losses and try to bet your way out of a hole. If after three months, you haven’t made any money, you may as well give up. Don’t love your position, if it clearly doesn’t love you.
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Spread Betting Margin Trading
Margin Trading The better needs to put up a deposit known as "initial margin":
For individual shares, initial margin is usually a given percentage of the notional value of your bet (e.g. 10% of your stake X the opening buy/sell price)
"Notional Trading Requirement" (NTR) on commodities, currencies, bonds and interest rates is usually a fixed multiple of the stake. If the NTR factor for a US 30-year T-Bond future is 64, initial margin is £640 at a stake of £10 per point.
The spread better needs to deposit sufficient margin with the bookmaker to support all the pen positions. The state of the margin account is monitored and if a "shortage of equity" materialises, the punter faces a "margin call".
Example Prodigal Life is trading at 207/208p. You take an up-bet on September Prodigal Life at £10 a point. The bookie's spread is 205/210 and 10% initial margin is required. The notional value of your up-bet is £10 X £210 = £2,100 but you only to deposit £210.
The shares fall 5% to 196.6/197.6 and the bookmaker's spread falls proportionately to 195/199. You are sitting on a paper loss of £150 (i.e. 210 - 195 @ £10) known as "variation margin" which is deducted from initial margin (£210) leaving an "equity balance" of £60.
However, the notional value of your bet has fallen to £1,990 (i.e. £10 X 199) which only requires initial margin of £199. You now have "shortage in equity" of £199 - £60 = £139 and face a margin call for £139.
If you don't come up with the £139, the bookmaker may close out your bet.
Spread Betting Arbitrage
Arbitrage is the practice of taking simultaneous and offsetting actions to exploit pricing anomalies. For example, lack of consensus in the "grey market" over the opening price of a new share flotation may be reflected in different bookmaker spreads, offering guaranteed gains to alert spread-betters.
Example
Bookmaker A quotes 220/225 on the opening price of an IPO while bookmaker B quotes 240/245.
The better places an up-bet with Bookmaker A from 225 and a simultaneous down-bet with Bookmaker B from 240 at, say, £100 per point. Both bets will expire on the first day of official dealing.
If the bet is held to expiry, a tax-free profit of £1,500 is made no matter where the settlement price finishes.
- If the price finishes at 235p Winnings with bookmaker A: (235-225) X £100 = £1,000 Winnings with Bookmaker B: (240-235) X £100 = £ 500 Total winnings: £1,000 + £500.
- If the price finishes at 210p Winnings with bookmaker A: (210 -225) X £100 = - £1,500 Winnings with Bookmaker B: (240-210 X £100 = +£3,000 Total winnings -£1,500 + £3,000 = +£1,500
Try it yourself at different prices.
Spread Betting Conditional Orders
Betters can limit risk exposure through placement of "conditional orders". For example:
- Limit Orders - Positions are opened or closed when specified price limits are reached.
- Controlled Risk Bets (CRBs) - The position is closed out automatically at a guaranteed price, albeit at the cost of a wider spread.
- Stop Loss - Normally free, but the bookmaker does not guarantee to close out the bet exactly at the stop price if, say, the market "gaps" to a new level.
- One Cancels the Other (OCO) - A combination of a stop loss and a limit order, placed at either end of the spread. When one order is triggered, the other is cancelled.
Spread Betting: Hedging
Sometimes you want to protect an investment against anticipated losses without liquidating existing holdings. If you believe that the markets are about to fall, you can hedge in two ways:
- 1:1 hedging hedging where your conventional market exposure is offset by an equal exposure to a spread bet - like a down-bet on the FTSE100
- Geared hedging by placing a spread-bet on an option - like an up-bet on a FTSE100 "put" (the right to sell the index at a given price) that rises in price if the index falls.
Last updated 21 January 2009