Essential Differences between Spread Betting and Share Dealing

Unless you have a professional trading background, there’s a good possibility that you will be migrating to financial spread betting after first trying your hand at conventional share dealing. It is therefore important to understand the essential differences between spread betting and share dealing.

How does spread trading differ from investing in shares?

It differs in many ways.

Advantages of Spread Trading include:

• You can profit from falling share prices as well as rising prices
• It’s free to open an account and you get free, easy-to-use charts on thousands of markets
• You pay a relatively modest “spread” on each trade compared with typically more costly broker commissions
• There is no stamp duty or capital gains tax
• Trades are executed immediately and you can set your own trade entry and exit levels
• Tools to limit your risk are at your fingertips including stop loss orders and decimal trading i.e. very small stakes
• It requires a much smaller outlay (typically 10-15%) to make the same profit as would be derived from buying shares
• You can protect or hedge an existing investment with a spread trade
• There is no currency risk when trading in overseas shares denominated in other currencies
• In addition to shares, you can trade indices, currencies and commodities
• You can do all your trading online or by phone and your funds are highly liquid

To be balanced, buying shares would offer some advantages:

• Investors have voting rights
• You receive 100% of dividends (you also get dividends with spread trading but typically it’s 80% not 100%)
• You have the choice of receiving advice from your broker.

Pounds-per-Point, not Pounds Invested

The most significant difference between spread betting compared with share dealing via a traditional stockbroker, and one that may seem strange when you first make the transition, is that you bet in terms of pounds-per-point rather than “investing” an amount in pounds.

When you invest £1000 in Big Bank plc (not a real company), you stand to lose £1000 if the company goes bust regardless of the price you paid for the shares. When you spread bet £1-per-point on Big Bank plc, you would stand to lose £1000 if the shares were priced at 1000p-per-share when you placed the bet but a lower £500 if the shares were priced at 500p-per-share when you placed the bet. If you really wanted to “invest” the equivalent of £1000 using a spread bet on a 500p-per-share stock, you would need to place a bet at £2-per-point.

At any given time, the profit or loss on your spread bet is the amount that the price has moved up or down since you placed the bet multiplied by your £££-per-point stake, and this is the amount that you win or lose when you choose to close the bet. The following chart illustrates a sequence of spread bet trades in which the trader loses £19 on a £1-per-point spread bet (because the price falls by 19 points) and then wins £36 on a £2-per-point trade (because the price rises by 18 points on his double-size bet).

Leverage and Margin

To “invest” £1000 in a company via a traditional stockbroker you would need to deposit the full £1000 with the broker. A spread betting company will typically allow you to deposit a smaller “margin” payment of let’s say 20%. So in this case you can make the equivalent of a £1000 investment by depositing only £200 with the spread betting company. But beware! In the absence of a stop order, you are still risking a full £1000, and the spread betting company will come knocking for the balance of £800 (it’s called a “margin call”) if your chosen stock goes bust. This is important, and one of the reasons that traditional investors don’t like leverage.

Leverage simply means that the spread betting company takes a smaller deposit than it actually needs to cover your full risk, and it lends you the rest of the money. It’s the same as when a bank or building society lets you purchase a £100,000 house with only a 20% deposit, and – just like the bank – the spread betting company will charge you interest for lending you the rest of the money.

The upside of leverage is that if the stock underlying your £1000 equivalent bet rises by 20% (lucky you) then you made not 20% profit but 100% profit on your deposit… because you only deposited £200 to cover your risk in the first place. The downside of leverage is that if the stock underlying your £1000 equivalent bet falls by 20% then your £200 deposit is totally wiped out!

Leverage has a good side and a dark side, a yin and a yang, but with the right risk-management mechanisms in place it is possible to learn to love leverage.

Shorting shares (often expressed as ‘going short’, or ‘selling short’) in effect means selling a share that you don’t in fact own because you expect that share will fall sometime soon, perhaps after a specific upcoming event. If you are right, you can then buy the shares in the market at a lower price than you sold them at.

Shorting is mostly done by large institutions and is not generally available to the average private investor. But spread betting offers a simple way to get the same effects of shorting a share and is available to anyone. It is a key benefit of spread betting in that it allows a knowledgeable investor to make money when the market is going down as well as when it is going up.

The Time Component of Financial Spread Betting

Unlike standard stocks trading, a financial spread bet includes an expiry date. That is to say, the spread bet closes at a particular time at which point you would settle any profit or loss. Assuming that you set up your bet and forget about it (NOT RECOMMENDED!) then the expiry date would come and the bet would be over.

However, you are free to to close the bet at any time before the expiry date if you so choose. This allows you to take advantage of any sudden favourable (or worrying) movements to either make the most of your bet, or to protect your losses. You can also set up an automatic ‘Stop-Loss’ that helps to protect any losses from spiralling out of control, which I will go into in a later post.

Most companies will also allow you to roll your bet over to the next expiry date if you wish, turning the bet into a longer-term prospect.

Overnight Financing and Rolling Charges

In exchange for providing the leverage on a smaller margin payment, the spread betting company will charge you interest in the form of overnight financing or rolling charges. On daily rolling bets, which may also be called Daily Funded Bets (DFB) or Daily Funded Trades (DFT), your account will be debited each evening by an amount equivalent to the London Interbank Offered Rate (LIBOR) plus a fixed percentage… divided by 365. With LIBOR at a low 1%, the interest rate you are charged maybe LIBOR + 2% = 3%. While the “rate” will be the same regardless of your bet size, the absolute amount will be proportional to your bet size.

If the overnight financing on your £1-per-point spread bet costs £0.01-per-day, a double-size £2-per-bet on the same stock or other financial instrument would cost you £0.02-per-day to keep open.

Just like when you invest in a buy-to-let property and you hope that your rental income plus capital appreciation will more-than-offset the costs of your buy-to-let mortgage, so with rolling spread bets you hope that the dividend receipts (if any) plus capital appreciation will more-than-offset the costs of the overnight rolling charges.

Say “No” to Dealing Fees and Commission

Unlike traditional share dealing, you do not pay a “dealing fee” or commission when you open or close a spread bet. Nor do you have to pay the 0.5% Stamp Duty Reserve Tax (SDRT) that is levied when you buy shares. All you pay is the difference between the buying and selling prices: the spread. Oh, and those overnight financing charges on any rolling spread bets that you hold for more than one day.

The situation is slightly different with Contracts for Difference (CFD), which are similar to spread bets and are offered by many of the same providers. You do pay commissions or “dealing fees” when opening and closing CFD positions.

Say “No” to Tax

Spread betting is often touted as “tax-free” because, as gambling rather than investing, you (currently) do not have to pay capital gains tax or income tax on your spread bet winnings. As well as providing a potential tax advantage compared with traditional share dealing, it’s also one less thing to declare on your tax return.

The situation is slightly different with Contracts for Difference (CFD), which are similar to spread bets and are offered by many of the same providers. You do pay capital gains tax on CFD profits.

Her Majesty’s Revenue and Customs (HMRC) in the UK is not necessarily missing a trick by not taxing spread bet “winnings”, because they do tax the profits of the spread betting companies just as they tax any other gambling firm or other organisation. If the HMRC taxed spread bettors individually, not only would it be an administrative nightmare, but also they might actually take less tax by allowing you to offset your spread bet losses against your other gains. And they know that, unfortunately, most of you will be losers!

Take note that tax laws can change, and they can also be subject to individual circumstances. Although there are no known cases to my knowledge, there is a theoretical possibility that the HMRC could propose taxing you as a “professional” trader if you derive all or most of your income from spread betting. It’s a grey area, but not one to get overly alarmed about since you are not even obliged to declare your spread bet winnings on your tax return.

Say “Goodbye” to Shareholder Perks

As well as saying “no” to dealing fees and tax, spread bettors also need to say “goodbye” to shareholder perks.

One of the benefits of holding shares was that some stock-holdings came with shareholder perks. Maybe you got a discount from the car rental firm whose shares you owned. Because you don’t own shares when spread betting, you don’t get any shareholder perks, but in these days of shares being held in nominee accounts I bet not many of you claimed your perks anyway. So you won’t miss them.