Spread Betting: What It Is & How It Works
The use of leverage is one way for an investor to enhance their returns, with the accompanying risk of magnifying the losses. There are several means to employ leverage. One option for some investors is to engage in what is called spread betting. While spread betting strains the definition of investing, it is nevertheless a way to make money from stocks, indices, and other types of securities through the use of considerable leverage.
What Is Spread Betting?
Simply defining spread betting can be controversial; it can be defined as a derivative investment strategy, but it can also be defined as gambling. Further blurring the distinction, most spread betting companies refer to themselves as “brokers”, and many of these “brokers” openly refer to a spread betting transaction as a “bet”.
Spread betting is essentially speculating on the future direction of a specified financial instrument like an individual stock or index by making a directional bet with the spread betting company. The bettor chooses the security in question (like an individual stock or stock index), decides on the size of the bet, puts up a small percentage of the notional trade value as collateral (margin), and then profits or loses money depending upon how the price of the underlying security moves.
With financial spread betting, participants never own (and never can own) the underlying financial instrument. When an investor buys shares in a company, they become literal part-owners of that company, and when an investor buys a commodity futures contract there can be at least a technical possibility of taking physical delivery of the commodity, though most futures are settled in cash.
Spread betting is illegal in the United States as of this writing. Most spread betting companies in the U.K. will not open spread betting accounts from U.S. residents but may offer Contract for Difference (or CFD trading).
Tip: Spread betting used to be legal in the United States and was conducted at places called "bucket shops". Bucket shops were blamed for contributing to two market crashes in the early 1900s, with the practice eventually banned in the early 1920s. Investors can read more about bucket shops in Edwin Lefevre's book 'Reminiscences of a Stock Operator'.
Sports Betting vs. Spread Betting
Just as with betting on a horse race or sporting event, spread bettors win or lose money based upon the outcome of the bet, though spread betting is not an all-or-nothing proposition like sports betting. It’s also important to note that the word “spread” means something different with financial spread betting than the term “spread” as it applies to sports betting.
- In sports betting, the spread refers to a minimum margin of victory.
- In financial spread betting, there is no such minimum, though bettors must buy-in at the ask price (the higher price) and sell at the bid price (the lower price), and that difference is called the entry spread and represents a built-in loss that must be overcome to have a profitable bet.
Spread Betting vs. Spread Trading
Likewise, spread betting and spread trading may sound similar, but they are very different. Spread trading involves simultaneously buying and selling related financial instruments to profit from a change in the underlying difference in value (the spread) between the instruments.
For instance, traders can play the “crush spread”, the difference between the value of a soybeans futures contract and the value of soybean meal and soybean oil contracts. This difference is the profit margin for processing soybeans into soybean meal and soybean oil and it can shrink or expand for a variety of reasons. If a trader believes that that margin is likely to change, they can engage in spread trading by simultaneously buying and selling soybean, soybean meal, and/or soybean oil contracts to profit from that change.
How Spread Betting Works
Spread betting works like this:
Step 1: Bettor Chooses a Security
The would-be bettor decides what security they wish to bet on from among those offered by a spread betting company.
Step 2: Bettor Chooses a Stake Size
The bettor then decides on the stake size—how much they want to bet on each point, or the minimum movement in the security price. A point will typically be equal to a penny per share for a stock and a point for a stock index futures contract but can vary for other instruments like commodities. In other words, a bettor can make a bet that will pay (or lose) £5 for every penny that a stock goes up or down or every one-point change in the value of an index futures contract.
Step 3: Stake Size Determines Notional Amount of the Bet
The stake size determines the notional amount of the bet—a £1 stake for a stock trading at £15 means a notional trade value of £1,500 (£1 per penny).
£1 x 1500 = £1,500
However, a £3 stake for a stock trading at £30 would have a notional value of £9,000.
£3 x 3,000 = £9,000
Step 4: Notional Amount Determines Minimum Margin
The notional amount of the bet determines the required minimum margin, which can range from under 5% to 20% depending upon the security and the spread betting company.
Step 5: Bet Is Executed
Once the minimum margin is in place, the bet is executed, with the bettor paying the worse of the offered spread (buying at the higher ask price or selling at the lower bid price). The bettor can end the bet at any time, doing so by reversing the transaction (selling at the bid price or buying at the ask price).
About Spread Durations
Spread bets have durations. Generally, bets either expire at the end of the day or at the end of a quarterly period (more typical with futures contracts).
- End of Day Expiration: At expiration, the bettor has the option to keep them open indefinitely in exchange for paying financing/holding fees.
- End of a Quarterly Period: Quarterly bets will often have wider spreads but lower financing costs. Any bet can be closed early without penalty.
Spread Betting Examples
To better understand how spread betting can work, consider the following example, which first includes an example of a regular stock transaction:
Example of a Regular Stock Transaction
An individual wishes to day trade in the shares of XYZ Plc, and those shares currently trade at a bid/ask spread of £100.00/£100.10, with a brokerage charging a £5 commission to buy or sell.
The individual decides to buy 100 shares and the trade is entered in the morning at £100.10 with a £5 commission, for a total cost of £10,015.
100 x £100.10 + £5 = £10,015
During the day the price of XYZ Plc shares increases by £5/share and the trade is closed successfully at a bid price of £105, with another £5 commission. The individual now has £10,495, earning £480 (before considering taxes).
(100 x £105) - £5 = £10,495
£10,495 - £10,015 = £480
In this example, the individual needed to have the £10,015 from the start of the transaction, or employ margin.
Example of a Spread Bet
Now consider that transaction as a spread bet.
First, that individual must decide on their bet size, also known as the “stake” – the amount of money they’re committing to each minimum price move of the underlying instrument. In this case, the investor chooses a stake of £1 per “point” (the point is the minimum price move for the instrument, in this case, £0.01 per share).
While XYZ Plc is trading at £100.00/£100.10 on the stock exchange, the spread offered by the spread betting company is £99.90/£100.20. In this case, then, the notional amount of the transaction is £1/point times the spread betting company’s ask price, or £10,020
£1 x 10,020 = £10,020
The broker requires a 20% deposit, or £2,004.
As in the prior example, the share price of XYZ Plc increases by £5/share and the investor decides to close the bet before the end of the day, selling at the betting company’s new bid price of £104.90. The profit from the bet is £470.
((£104.90 - £100.20) x £1 per £0.01) = £470
That is almost the same profit as in the earlier example (£480), but there are no taxes later, and the return on initial investment is much larger—more than 23% (£470/£2,004) versus 4.8% (£480/£10,015).
Example of Spread Bet with Falling Shares
Now consider an example where the value of XYZ Plc shares falls. In this case, the share price falls just £2 to £98.00/£98.10, with the bettor seeing a spread of £97.90/£98.20 from his spread betting company. The value of the bet has now declined by £230.
(£100.20 - £97.90) x £1 per £0.01 = £230
This leaves £1,774 from the original deposit, or a 11% loss.
If the investor had purchased the shares and seen a similar decline, the loss would have been £205 just over 2%, and that loss would be tax deductible.
(((£100.10 - £98) x 100) - £5) / £10,015 = 2%
In this example, the person bought and sold within a day. This is an important detail because of the impact of financing/holding costs. If the share price hadn’t moved at all (ending the day at a bid/ask of £100/£100.10) and the individual chose to carry over the trade to the next day, it would incur an extra cost of around £7 to £9 (at typical spread betting company rates as of this writing). That cost would be incurred every day the trade was open while acquiring the shares for cash would incur no day-to-day costs.
Managing Spread Betting Risk
Since spread betting involves large amounts of leverage, risk control is a key concern and a key element to long-term success. Setting maximum allowable losses is a useful strategy for limiting risk and can be achieved through stop loss and guaranteed stop loss orders.
A stop loss order allows a spread bettor to limit risk by establishing a predetermined price at which the broker will close the transaction. Many brokers require stop orders on every trade, and that may include an automatic stop loss order entered when the initial transaction is executed.
Tip: Stop loss orders do not offer perfect protection. When the specified price is reached, the stop loss order becomes a market order and there can be slippage between the price of the stop loss and the actual price at which the transaction is closed out – this slippage can be larger in periods of elevated volatility and is also influenced by how quickly the spread betting broker executes transactions.
Guaranteed Stop Loss Orders
Most brokers now offer guaranteed stop loss orders (or GSLOs) in addition to regular stop loss orders. Guaranteed stop loss orders ensure that the trade will be closed at the specified price, irrespective of what happens in the market to the underlying security or the broker’s execution—if a stock or index gaps lower at the open and beyond the GSLO level, the bettor will still see the bet closed out at the guaranteed price.
Spread betting companies require bettors to pay an additional fee for a guaranteed stop loss order, and that payment may be charged on the front end of the transaction (so the participant pays the premium whether or not the guaranteed stop loss order is executed) or only if executed. The cost of a GSLO is usually expressed as a multiple of the stake or a percentage of the notional trade value. As is the case with virtually all fees with spread betting, there will be company-to-company differences in the cost of GSLOs, and companies compete on both the cost and whether it’s charged upfront or only if used.
Advantage of Spread Betting
Spread betting is essentially a way to make highly leveraged directional bets on markets, stocks, commodities, and other securities. There are definite advantages to spread betting for some individuals, but many of these advantages carry “fine print” that participants must consider.
- Leverage: Spread betting allows participants to employ leverage to a degree that is otherwise not typically possible with conventional margin trading, as spread betters can establish positions with 3% or less of the total transaction value in some cases. While this is often touted as a major advantage of spread betting, the high degree of margin can quickly lead to significant losses.
- Lower Limits: Participants are also not subject to the same limits on marginable securities or minimum transaction sizes. While a U.S. investor who wishes to trade on margin must have a minimum of $2,000 in their account, a spread bettor could make a bet on a stock with a much smaller stake (£100 or less).
- No Charged Commissions: Spread betting companies like to focus on the fact that spread bettors are not charged commissions, but this does not mean that betting is free. Bettors have to pay the entry spread (buying at the ask and selling at the bid) and that spread is determined by the company. Depending upon the size of the spread and frequency of trading, bettors may pay more in entry spreads than they would in commissions, but spread betting companies do compete on the tightness of the spreads they offer.
- Favorable Tax Treatment: Many countries have favorable tax treatment for this type of transaction. In the United Kingdom, for instance, the profits from spread betting are not subject to capital gains taxes or stamp duties. That benefit is mitigated by the fact that losses are not tax-deductible.
- Access to Specific Financial Products: It allows participants to access financial products that may not otherwise be available, including stocks listed on foreign exchanges and derivative instruments (like futures contracts) that may otherwise have substantial minimum investment requirements.
Spread betting got its start in the U.K. in the 1970s primarily as a way for individuals to speculate on the gold market; a market that at that time was very difficult for individual investors to access. Practically speaking, the only limits on spread betting are what spread betting companies are willing to offer, so spread betting can be done with thousands of individual stocks, stock indices, interest rates, currencies, commodities, and other financial instruments.
Tip: Most spread betting companies require spread bettors to use the full available margin.
Spread Betting Limitations
Spread betting also carries several significant limitations that participants must consider.
The most significant of these limitations is that the bettor never actually owns the underlying asset. While an investor who buys shares with cash and sees the price decline can choose to wait for a recovery in the price, the combination of holding costs and margin requirements can force a spread bettor out of their position before any recovery can take place.
1. Fees
There are also numerous fees that apply to spread betting.
First, participants must pay the entry spread, buying at the ask price and selling at the bid price. If shares of XYZ Plc are trading at a bid/ask spread of £100/£100.10, a spread bettor would buy at £100.10 and would immediately have a £0.10/loss if they then closed the position (selling at the £100 bid). It’s important to note, though, that the spread a spread bettor pays is set by the spread betting company will usually be different (worse) than the spread in the actual underlying market.
Spread bettors will also be subject to financing charges (also called holding or funding charges) if they hold their positions overnight. In essence, this is similar to margin loan interest charges but charged on a daily basis. The amount of the financing charge is calculated as the end-of-day notional position value times the interest rate divided by 365 (some brokers will use a different denominator for some instruments, like U.S. stocks). The amount is then automatically deducted from the account.
Some brokers will charge fees on funding and withdrawal transactions, as well as “exchange data fees” and account inactivity fees. Brokers often compete on the basis of these fees and it is a good idea for bettor to shop around and consider multiple spread betting companies before starting spread betting.
2. Margin Calls
If a spread bet moves against the bettor they may face a margin call. Margin calls are triggered when the equity of the bettor’s account falls below a threshold established by the spread betting company and/or regulators. Once the threshold is breached, the bettor must deposit more cash or close some open transactions to raise the equity level back above the minimum threshold.
Most U.K. spread betting firms have maintenance margins of 80%, meaning that investors must maintain an equity value of 80% or more of the initial margin. Spread betting accounts will also have a pre-specified margin closeout level—if the equity value of the account falls below that level, the broker will automatically start closing out open positions. In the U.K. there is a regulatory closeout requirement at 50%, but companies can have higher minimums if they choose.
There are important differences between spread betting margin calls and typical equity margin calls. The most significant is that a retail spread bettor’s losses are limited to the money in their account—due to regulator-mandated negative balance protection (which ties in to the mandatory closing out of positions if the account falls below the 50% threshold) bettors cannot lose more than what is in their account. While the losses from an individual trade can exceed the initial margin amount, the maximum loss is limited to the value of the account.
3. Wide Spreads
Another limitation in spread betting is that the bid/ask spreads in spread betting are decided by the spread betting company. While they will be related to the current bid/ask spread of the underlying financial instrument, the companies make their profits in large part off of those artificially-widened spreads.
Brokers compete on the combination of their spreads, as well as the range of products they offer, the quality/speed of execution, margin requirements, and various fees. Some brokers may offer wider spreads, but offer access to spread betting on financial instruments that other brokers do not offer. Spreads can widen during periods of elevated volatility and can vary between similar instruments in the same class (different stocks or indices could have different spreads).
CFD Trading vs. Spread Betting
A contract for difference (or CFD) is a short-term leveraged derivative contract between an investor/bettor and a spread betting firm that tracks the value of a specified underlying financial instrument (like a stock, stock index, commodity contract, et al). CFDs are always settled in cash and there is never a physical delivery of the underlying instrument.
Similarities:
- Leverage: CFDs are similar to spread betting in most respects, including the significant leverage employed.
- U.S. Law: Both are currently illegal in the United States.
Differences:
- U.S. Access: Unlike spread betting, many companies that offer spread betting and CFDs will allow residents of the U.S. to trade in CFDs.
- Prices & Stake Size: With spread bets, the bet is based upon a spread quoted by the spread betting company and a stake size decided by the bettor. In most cases, CFDs will be priced upon the actual underlying market bid/ask spread, and there is no discretion in stake size—each CFD is equivalent to one “unit”, be that a single share of stock or a specific tick value for stock indices, commodities, bond/rates, et al.
- Charges & Fees: Also unlike spread betting, trading CFDs will incur commission charges and transaction fees, as well as capital gains taxes (but not stamp duties). While the capital gains from trading CFDs are taxable, the losses are also deductible —something that is not true of spread betting losses.
Pros & Cons of CFDs
The advantages and disadvantages of CFDs are largely similar to those of spread betting—namely the opportunity to employ significant leverage to profit from the price movement in the underlying security, but with the risk of larger losses compared to trading strategies that do not employ leverage.
- Main advantages of CFDs vs. spread betting: Foreign investors who are not allowed to engage in spread betting can trade in CFDs, and there are usually no expiration dates with individual stock CFDs, though as with spread bets, there will be expiration dates if the underlying instrument has an expiration date (like a futures contract).
- Main disadvantage for CFDs vs. spread betting: Profits on CFDs are taxed as capital gains. Commissions may also factor in as a larger cost for traders depending upon the frequency of their trades, their holding periods, and the spreads charged by their spread betting/CFD company for spread bets on the same instrument.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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