Is Spread Betting Dangerous?

Some popular ‘investment’ web sites steer their readers away from financial spread betting on the grounds that it is dangerous compared with traditional investing. But I think they’re dead wrong.

I think that first-time financial speculators might benefit from trying their hands at spread betting before embarking on a journey down the traditional investment road, because:

• Spread betting allows you to get started with very small stakes, less than £1000, whereas traditional investment requires a much larger pot of cash in order to achieve meaningful diversification.
• Spread betting encourages you to hone your money – and risk – management skills by making protective stop orders (for example) both necessary and obvious.

In my opinion, if you can’t make money by spread betting then you are unlikely to be able to make money as an investor or trading the financial markets whether this is shares, options, futures…etc

The one caveat is the fact that spread bets are leveraged or geared, which means that you could lose (and owe the spread betting company) more than the amount you deposited with them initially; but no more than you would lose on a size-equivalent traditional investment in the same market. I’ll return to this theme in a later chapter, but in simple terms:

• A £200 deposit leveraged up to £1000 via a spread bet puts the larger £1000 ‘at risk’.
• A £1,000 investment puts exactly the same £1000 at risk for exactly the same reward.

So what’s the difference?

Once you realise that in a spread betting account you are actually risking the higher leveraged amount, and that your risk is exactly the same as having invested the higher amount in the traditional way, you discover that spread betting is no more dangerous than any other form of financial speculation – including the supposedly-more-sensible ‘investment’.

With the market mayhem of recent years, you might think that you’d have to be mad to consider spread betting or any form of financial speculation. But I see it like this:

If you can make it work (or fail not too badly) during times of market meltdown then you should be able to reap the rewards when the good times roll.

Who is Spread Betting not for? Spread betting is not for anyone under the age of 18. It’s also advisable if you have any kind of gambling addiction or have suffered from a gambling addiction in the past to leave financial spread betting well alone. The risks associated with spread betting are very high and it’s important that you understand these before you get involved

Who is Spread Betting for? Spread betting is open to almost anyone in the United Kingdom, parts of Europe and certain countries in the rest of the world. Since Spread Betting in the UK is classed as gambling, it’s not open to children under the age of 18. Other than that anyone can do it. It doesn’t matter if you’re a teacher, window cleaner, graphic designer, work in McDonalds or are a city banker. If you have access to an internet connection or phone and have money you can afford to risk on spread betting then anyone can do it.

When trading it is really important to understand how leverage works. Trading is different to investing and different rules apply – set clear goals for your trades, use stops, cut losses, and know how much you are putting at risk at all times.

Let’s take an example. If you take a long spreadbet on the Footsie 100 for £10 pounds per “point”, you may only be asked to deposit a few hundred pounds to open this trade, but your market position is actually £10 x the index – presently £10 x 6590 = £65,900, which would be equivalent to investing £66k into a FTSE tracker exchange traded fund.

One word of caution beginning traders with limited capital over leverage. So even though you may have enough trading resources in your account to open a €10 a tick trade on a particular share trading at $20.00 a share (or 2000), don’t do it, start with €1 a tick. Opening a €1 a tick trade may seem pointless initially, but if the stock rises to $24 or $25 and you make €400-500 that’s all you need initially. If you can have one or two of these trades on the go at any one time you’ll soon build up the resources to trade larger stakes. If on the other hand you jump straight in there with your €10 a tick trade, yes the share might go to $24 or $25 and you would make €4,000-5,000 on the trade, but it could just as easily go against you and drop to $15 a share and then your nursing a €5,000 loss. It won’t take too many of those losses to bring an abrupt end to your spread trading career!

I think a lot of people fail to understand this and get caught out when they see wild fluctuations in their profit/losses and in some cases end up losing more than they were initially prepared to risk.

Disadvantages / Risks

Outlined below are the main disadvantages and risks of spread betting over traditional share investments:

No Dividends

As traders never take ownership of the actual shares they trade they therefore are not entitled to any dividend payments which may be due to shareholders. Some shares don’t pay a dividend but others can pay a dividend which can be up to 10% or higher per year.

No Voting Rights

Similar to not qualifying for dividend payments, likewise spread traders are not entitled to attend the AGM of companies which they spread trade and have no voting rights at these meetings.

You can’t offset losses against Tax

If you purchase and own shares (as opposed to spread trading) and you end up making a loss on your shareholding when you sell them, under current Irish tax law you are entitled to right that loss off against other income, thus reducing your overall tax liability. When you spread trade, because it is a bet rather than an investment, you cannot offset any losses incurred against other income. While there are benefits in being able to offset losses incurred against your tax liability when you purchase shares, it could be argued that one’s goal when investing should not be to incur losses in the first place!

You can lose more than your Initial Investment

By far and away the biggest risk associated with Spread Trading is the fact that you can lose more than your initial investment. With traditional share purchases, the most you can lose is the money you spent on those shares (which only happen if the shares went to zero).

With Spread Trading however, you can lose more then your initial investment. Lets take our CRH example again, you decide to Buy (go Long) CRH at €17.00 per share (1700) at a stake of €10 per tick. At an IMR of 15% the amount of money you need to have in your spread trading account to complete this trade would be €2550. Now lets take a scenario where CRH announce a profit warning or some other news that the market does not like and CRH’s share price opens up much lower, say at €10.00 per share (1000). In this case your spread trade on CRH would now show you down €7,000 (700 ticks at €10 per tick). In an absolute worse case scenario lets say CRH went to zero, you would then be down €17,000. While this may seem an unlikely scenario it can happen, think of recent examples such as AIG, Anglo Irish Bank, Northern Rock, Nortel Networks to name a few which highlight that the risks involved in spread trading can be very high.

Stocks can Gap Lower or Higher than your Stop Loss

Related to the previous point is the fact that just because you have a Stop Loss in place that does not guarantee that your losses will be limited to the amount of your stop loss. A stop loss is an automatic order to close out your position if the price its a certain level you set. Stop losses are an excellent idea and should always be used. However it is important to remember that sometimes prices can gap up or down based on specific share news or just as part of the general market sentiment. If the market gaps to a price beyond your stop loss your spread trading company will attempt to close your position at the best price they can get on the market. This can result in you losing more money on the trade than you had originally budgeted for when you set your stop loss.

I know this is Not What You Want to Hear

Not so long ago I had a one-to-one session with a friend of a friend who wanted to get into financial spread betting. Although he was more than happy with what he paid for the “education” I provided, I could tell in his eyes and in his voice that he wanted something else, something that I didn’t give him. That something was ‘excitement’.

Ah, I remember it well – those days when I to dreamed of quitting the rat race to make millions from the comfort of my own home after having read just a few books about financial trading. How I imagined myself metaphorically shouting “buy” into one phone while simultaneously shouting “sell” into the other phone. Yes, that’s what he was thinking too.

I was sorry to have to tell him, and I’m sorry to have to tell you, that it really isn’t like that. It can be a hard and costly slog learning the spread betting ropes, and you can take two steps backwards for every three steps forward on the road to achieving any degree of consistency. And when you think you’ve got it cracked, the market will humble you once again. Or even worse, it won’t, and you’ll think you’re the master of the universe that you always believed you were.

And yet, I have found that if you forget about the excitement and the lure of the untold riches, and concentrate on devising an approach that reduces risk (perhaps using stop orders) then one day something good might happen.

Summary

In this section we have looked at what financial spread betting is, how it is similar to – yet different from – traditional share dealing, and how the “costs of doing business” compare over different time periods. I have suggested that leveraged spread betting may be better thought of as a way of turning a small amount of capital into a large amount of capital rather than as a vehicle for preserving existing wealth.