How Spread Betting Works

Spread betting is a form of derivatives trading. It enables you to speculate on the direction that the price of a financial instrument (such as a company share, stock index, currency pair or commodity) will move. The further the price moves in the way you predicted then the more money you make. However, you can also lose money if the price moves against you.

Leverage

With spread betting, you don’t actually buy the underlying asset you want to speculate on. Instead you take a view on the prices offered by a spread betting provider, such as Spread Co, as to whether the price will rise or fall. As you don’t have to buy (or sell) the underlying asset, spread betting providers allow you to trade on ‘margin.’ What this means in practice is that you only have to put up a small percentage of the value of the underlying asset to control a large amount of it. In other words, you are dealing with leverage. As a result, your potential profits are magnified, but so are your losses. For this reason, great care must be exercised in spread betting. Fortunately, companies like Spread Co offer a number of ways to control your risk, such as stop losses and guaranteed stop losses.

An Example

Let’s consider the FTSE100 (the index of the top 100 UK companies by market capitalisation). Spread Co is constantly making a dealing spread, or quote, on the ‘UK100’, based on the underlying FTSE index. This quote consists of a bid (selling) price and a, slightly higher, offer (buying) price. The spread between the two can be as narrow as 0.8 points, which means that Spread Co’s charge for opening and closing a spread bet is one of the lowest available. Let’s assume that you get a dealing quote of 6920.0 to 6920.8 – this means that you can ‘sell’ at the lower bid price of 6920.0 or ‘buy’ at the higher offer (or ‘ask’) price of 6920.8.

Let’s say you think the index will rise, so you ‘buy’ £1 per UK100 point at 6920.8

Now it’s very important to understand exactly what ‘one point’ means, as it varies across different financial instruments. As far as the UK100 is concerned, a point is 1.0, so if you buy the UK100 at 6920.8 and subsequently sell it at 6921.8 (in other words when our spread on the UK100 is 6921.8 – 6922.6), that is a full point. In this example, for each point the UK100 goes up, you will make £1.

Let’s say our UK100 rises to 6973.6 soon after you open your position and you decide to close out your bet – your profit will be £52.80 (6973.6 – 6920.8= 52.8 x £1).

And one of the great advantages of spread betting is that you can speculate on a market (including individual company shares) falling as well. So if you thought that the UK100 was set to go down in value, you could have sold at 6920.0.

On top of this, spread betting providers like Spread Co make two-way prices on certain financial instruments even when the underlying markets are closed. They charge a wider spread for this service, but it can be well worth it when you consider how world events and fresh news stories are moving markets all the time.

Risk

But there are risks as well as rewards in spread betting. You can make a lot of money quickly from a relatively small outlay, but you can lose money fast, too. Let’s take the above example again, where you bought £1 on the UK100 at 6920.8. If the underlying index fell, instead of rising, and you ended up selling your position to close at a price of 6855.4, you would lose £65.40 (6920.8 – 6855.4 = 65.4 x £1).

Notional Trading Requirement

So you can lose money if your trade goes wrong, or if you experience a market move against you before you are able to close out your position at a profit. For this reason, spread betting providers require you to hold a certain amount of money in your account before you can open a trade. This is a deposit called the ‘Notional Trading Requirement (NTR)’ and it varies in size depending on the market. Taking the UK100 as an example, Spread Co asks for 25 times your stake as the NTR. So, to make a £1 bet on the UK100, you need to have £25 of unencumbered funds (in other words, money not needed for other positions) in your account. It is important to understand that this is the very minimum requirement though. Markets are constantly fluctuating. Consequently, it is important to have additional unencumbered funds available in the account to cover adverse market movements. If these resources get exhausted though a negative market move, Spread Co would ask you for additional funds (variation margin) to keep the position open.

Risk Management

One of the keys to successful spread betting is risk management. This involves carefully planning a trade before putting it on and always using a stop loss. A stop loss is an order to close out a trade at a level specified by you. So, in the above example, when you bought £1 per point at 6920.8, you could have simultaneously placed a stop loss at 6894.0. Then, if the market moved against you, and below your stop order, your spread bet would have been closed out at 6894, assuming no price gapping had occurred.

A stop loss shouldn’t be placed at any old level. It should be chosen with a careful consideration of significant technical levels (such as support and resistance) together with careful money management.

Price Gapping

In the above example, we mentioned ‘price gapping.’ That’s where the market is moving fast and the price ‘gaps’ or jumps over or below your stop-loss, without trading at that specific price. It can also happen when a lot of orders are triggered together, which often happens around large round numbers and significant technical levels. A ‘stop-loss’ becomes a market order as soon as the stop-loss price is hit or exceeded. This means the bet will be closed at the market price closest to the specified price on a first come, first served basis. Consequently, you may not get out at the level you expected.

The solution to this problem is slightly more expensive but well worth considering: the guaranteed stop. Guaranteed stops are available on many spread bets. For a small additional spread on the bet opening, this guarantees your stop price – no matter what happens in the underlying market. This can offer you complete peace of mind – even in the most uncertain market conditions.

by David Morrison of Spread Co

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.