Financial Markets - Spread Betting

A spread bet can be described as a type of derivative trading. A spread betting company is in actuality a business providing a user friendly interface to speculate in derivatives.

For instance, a trader may think that the FTSE 100 is about to go up. A Liffe trading account could be opened and a contract bought. Nevertheless that contract would involve him making a £50,000 bet on the direction of the FTSE 100. That is the minimum size of a FTSE 100 Liffe contract.

A spread betting company, will let you place a smaller bet on the FTSE 100 in that, it can roll up all the vulnerability to these gambles in a batch and proceed to lay this off by buying the large Liffe contract on the Liffe market. Basically, it often acts as an aggregator of many small bets, turning them into one large market position. This allows the spread betting companies the ability to offer FTSE 100 spread bets or Dax spread bets at any size you require, reducing to as little as a penny a point.

Spread betting concepts in high finance
At this stage it is probably a good juncture to revisit some spread betting basics. A spread bet affords a speculator the chance to bet long or short on a wide range on financial instruments at a 'bid offer spread'.

A spread better could purchase Vodafone at 102 and dispose of it at 100. Where the FTSE 100 is concerned, there will be a six-point spread. You will be able to purchase a position at approximately 4,006 and sell it at 4,000. A six-point spread will always be inbetween the price you can buy and the price you can sell. A gross of six points can be made by every spread better for every completed trade. Similarly, on the aforementioned Vodafone spread, he will make two points on every trade, either long or short.

If you decide to bet a pound a point on the FTSE 100, the spread betters' charge for this position would amount to £6. This might not seem much, but at £10 a point, the position costs £60 a trade, and at £100 a point, it costs £600 a trade.

The cost of laying off a bet on the market is the only trading cost of the spread better.  This may be an only point on a liquid market like the FTSE 100 or an equivalently tiny percentage on the Dow or S&P 500, so he has a credible margin after passing on the risk of five points.

Also, if you paid £6 to go long at £1 a point and someone else paid £6 to go short at £1 a point, the spread better has a natural hedge and won't lose on these two bets in aggregate. He has made a profit of £12 and can sit back and watch both parties cancel each other out in his books.

Regrettably for the spread betting company, speculators in the market are seldom in two minds, The betting will be all long or all short and bookies are often forced to lay off their exposure in the market, at their own expense.

Most people combine spread betting with equities and indices, there is a glut of markets covered by modern spread betting companies. In this day and age, the universe of speculation has spread to currencies, bonds, interest rates, traded options, commodities and even house prices.

For a trader this is an exhilarating menu of opportunity. To go straight to market access to all of these instruments would be fabulously time consuming and expensive, whereby a spread better, for a modest tariff, opens up all these avenues with a single online account.

Tinkering in Libor futures is not for the faint hearted, but nonetheless, market access in its own right is an asset even if you never take a position. Take for instance, with an open account, you will never miss that opportunity to make a killing in a particular currency, because it takes away the need to spend a couple of weeks opening a currency trading account.

The benefits for equities are more obvious. There isn't any stamp duty on a spread bet. In the case of an intra-day or active trader, a 0.5% tax is a near impossible hurdle to vault. A trader should think about shielding himself from this expensive barrier and can do so with a spread bet.

This is a tax advantage that contracts for difference (CFDs) also enjoy, but spread betting has a spectacular added benefit. Taxation doesn't apply on profits from spread betting, unless the revenue can prove you are a pro. Cynics are swift to point out that you must first make a profit, but still, this tax break is an extremely attractive feature.

Make your cash work harder for you
One more appealing feature of spread betting is leverage. To the non-gambler, leverage isn't a benefit but a demonic temptation. As a rule, a spread betting firm will give an index speculator 20 times leverage. Consequenlty, if you want a £1 a point exposure to the FTSE, which is worth £4,500 of exposure, you can have it for just £225.

Of course if the market runs against you, soon you will be called upon to top up your account. Nevertheless, the advantage of leverage if you are right can be immense. This is a powerful attribute for those with either absolute faith in their judgment or, as some may suggest, a lack of understanding of the fundamentals of risk. If a bet is placed for £225 into his account and then takes a £1 a point bet on the FTSE and the market goes up 225 points in a month, he will double his money. It doesn't need recourse to a sophisticated spreadsheet program to work out the impact of doubling your money each month. At that rate, a little money becomes a lot of money in a relatively short period.

It is extremely difficult to always be right, and high leverage can act very much against a speculator's chances. The laws of over-betting indicate they will most probably get forced out of their position by a contra-move caused by general volatility. This consigns the speculator out of the game for good even though his position might be proved to be generally correct in the long run. The result of leverage if you make the wrong move proves as powerful in destroying capital as creating it.

One thing to bear in mind is that where leverage is concerned, it is not compulsory to use it. As with any tool, understanding its impact and its range of applications can turn it from a blunt instrument into a useful device.

Hedge your wedge
Spread betting has more applications than it is often acclaimed with. It's sometimes considered as a trading or short-term investment tool, but underlying the conception and use of derivatives is the concept of hedging.

For instance, anyone with a sizable portfolio might reach a point where they are worried that the market might crash. Traditionally, they have hardly any options but to sit tight or sell out. The trouble with selling is that the costs can be significant. Brokerage fees, spreads and also the calculation of tax liabilities can be very costly.

For example, a portfolio is worth £1 million. To purchase or dispose of could total 2% brokerage, 0.5% stamp duty and 1% spread. That is a total of £35,000. To opt out of the market and then to re-enter later is therefore an expensive manoeuvre.

However, by disposing of £50,000 worth of stock and lodging it with a spread better, the entire portfolio could be hedged against the FTSE 100 for three months for around £1,400. Taking a risk with a few hundred more could result in another three months being tacked on.

It would be an expensive pain if the market continued to go higher, but once more, powerful tools shouldn't be wielded lightly.

One of the disadvantages of spread betting is that it is easy to misunderstand the risks and costs. For instance, the spread - and therefore cost - of a FTSE 100 or Dow spread bet can seem small. In view of this, many will try to trade the intraday moves of an index in order to capture very short-term moves.  Alternatively, if you crunch the numbers, it becomes clear that the spread represents around 10% of the daily range of the index price. This is a big obstacle to jump to make a profit and the possibility to profit in the long run begins to shrink horribly if you were to trade several times a day.

Presumably, contracts are of a finite period, and renewing contracts quarterly can add up to a big cost.  Personally, on equity spread bets, consider taking longer-term contracts where possible. On a per day basis, these work out cheaper than short period bets. Timing is particularly difficult to judge, and moves, even when you are right, very often take longer to occur than expected. Like most serious trading or investment, cost controls can be as important as risk management in delivering final returns.

Hardly any spread betters understand the amount capital they have at risk when using leverage. I have explained several times to active index 'traders' who are aghast when I explain that their £50 a point on the Dow is a £500,000 capital at risk position. Obviously, the market volatility means that they cannot lose ALL of that £500,000, but markets have dropped 25% in a day or two, and will do so again. With an awareness of capital at risk, disaster can be avoided, but the user friendliness of spread betting can allay people into a false sense of security.

However, after stating all these facts, I maintain that any serious investor or trader should have a spread betting account. The volume of markets that are able to be found via today's online spread betters is a feast for anyone with a head and heart for speculation. While certainly not for the inexperienced, spread betting is an adaptable, cost effective and user-friendly way to gain access to the biggest games in town.