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Starting off our new series on Financial Spread Betting, today we look at what is spread betting, who uses it, for what purpose, and how it actually works in practice.
Understanding OTC Derivatives
Financial spread bets and their close relative Contracts for Difference (CDF) are off-exchange, OTC (over-the-counter) derivatives. That is, financial instruments not traded on exchanges and whose value is derived from underlying securities. They are essentially contracts traded and negotiated directly between the two parties – the spread betting company and you, the client – without going through an exchange.
Financial spread betting offers retail traders easy access to a large number of international markets, ability to take long and short positions and high leverage. It is only suitable for (short-term) trading, not for long-term buy & hold investment.
When spread betting, just like trading CFDs and other derivatives, you are not actually buying or selling any shares. You are simply betting on the price movement of the underlying share (or commodity, index, currency, etc). And, thanks to leverage, you get exposure to the markets at a small percentage of the cost of owning the actual underlying instrument.
Spread betting was first offered in 1974 by IG Index in the UK. It has grown rapidly since the late 1990’s thanks to the introduction of online dealing. Once the preserve of City traders, financial spread betting has grown in popularity among ordinary investors in recent years. This is especially true in the UK due to the favourable tax status (spread betting gains are tax-free under UK tax laws). Today there are an estimated 250,000 people in Britain alone that engage in spread betting.
Although most attractive to individual traders, spread betting is also occasionally used by professionals and funds for speculation and hedging risk exposure. Institutions, however, generally favour CFDs for a number of reasons, including higher transparency and cost effectiveness in large transactions. (We will explain the similarities and differences between spread betting and CFDs in another article.)
Financial spread betting is now available in a number of countries, including the UK, Ireland, Canada, Australia, South Africa, much of Europe and parts of the Far East. It is, however, prohibited in the US (along with CFDs) due to SEC restrictions on OTC derivatives. In the UK financial spread betting is regulated by the Financial Services Authority (FSA).
The role of the spread betting company
It is important to understand that the bid and offer prices, although based on the actual market price of the underlying instrument, are set by the spread betting company (the market maker). Therefore, the price you will trade is not the exact price you see in the market. The spread will typically be slightly wider; this is how the provider makes money (instead of charging a commission as in CFDs). The spread betting company also defines the contract terms, margin rates, what underlying instruments you can trade, etc.
The companies are not allowed to give advice – spread betting is always execution-only.
Purpose of financial spread betting
Spread betting is most commonly used for speculation on price movement of equities, indices, commodities, currencies. You make a profit if the price of the underlying security moves in the direction you expected.
However, it can also be used as a hedge for your long term portfolio. (We will look at this aspect next time.)
How does it work?
A financial spread bet is a contract between the customer and the provider to exchange the difference between the opening and closing price of the bet. Your profit or loss is the difference between the opening price and the closing price multiplied by your stake.
So, what exactly is the ‘spread’ and ‘bet’ in spread betting?
‘Spread’ refers to the difference between the bid and offer price quoted by the spread betting company. The higher price (offer price) is what you can buy at, the lower (bid price) is the price you sell.
The ‘bet’ size, or stake, is the (GBP in the UK) amount you choose to bet per point movement. There is no standard contract size; you nominate your own stake. Most spread betting companies allow you to go from £1 per point up to several hundreds (and more) pounds per point.
The spread betting provider will quote a bid-offer price for the DOW, say 10,546–10,548. You think the price is heading down, so you sell 10,546 at £5 a point. The DOW falls to 10,473, or 10,472-10,474 as in provider’s bid-offer price, and you close the trade (essentially making a buy bet). Your profit will be the difference between the closing price of 10,474 and the opening price of 10,546, times £5. That means 72 X 5 = a profit of £360.
Of course if the DOW starts to rise above the level at which you sold, your trade will instead start incurring a loss.
If you’re new to spread betting, it’s a good idea to practice on a trading simulator (or demo account) first. Many spread betting companies allow you to practice on their platforms without putting real money in. Of course the psychology and emotions are quite different when you trade a dummy account as opposed to having real money at stake. It is a good way to become familiar with the platform and the process though.
So, is spread betting gambling?
No, it isn’t. Unless, of course, you consider all financial trading to be gambling. Perhaps it’s fair to say that it comes down to the way the individual uses the product. Traders who jump into markets without any strategy or risk management and trade on gut instincts are indeed little more than gamblers.
The term ‘betting’ is a bit unfortunate and misleading, which is why many prefer to call it spread trading. However, the tax-free status comes from the fact spread trading is (in the UK) classified as ‘betting’, even though it is regulated by the FSA. For example, CFDs, although very similar to spread bets, are not a tax-free instrument.
Interested in learning how to profit from financial spread betting?
Starting with the basics of financial spread betting, we will be adding more articles and free guides each week, including details of various profitable strategies. Next time you will learn all about the benefits and risks of spread trading and what you need to be a successful trader.