What is spread betting?

Spread betting is a derivative strategy in which participants do not own the underlying assets they bet on, such as stocks or commodities. On the contrary, spread traders simply use the prices provided to them by the broker to speculate whether the price of the asset is going up or down.

Like stock market trading, spread betting has two quotations-the price you can buy (the buying price) and the price you can sell (the selling price). The difference between the buying price and the selling price is called the spread. Spread betting brokers profit from the spread, which makes spread betting without commission, which is different from most securities trading.

If investors believe that the market will rise, they will be consistent with the buying price, and if they believe the market will fall, they will be consistent with the selling price. The main characteristics of spread betting include the use of leverage, the ability to go long and short, the diversity of available markets, and tax incentives.

Key points

  • Spread betting allows traders to bet on the direction of the financial market without actually owning the underlying securities.
  • Spread betting is sometimes advertised as a tax-free and commission-free activity that allows investors to speculate in bull and bear markets, but this is still banned in the United States
  • Like stock trading, stop loss and take profit orders can be used to reduce spread risk.

The origin of spread betting

If spreading bets sounds like something you might do in a sports bar, then you are not far away. Charles K. McNeil (Charles K. McNeil) is a mathematics teacher. He became a securities analyst in Chicago in the 1940s and later became a bookmaker. He is widely believed to have invented the concept of spread betting. But it originated from the activities of professional financial industry traders about 30 years later, on the other side of the Atlantic Ocean. City of London investment banker Stuart Wheeler (Stuart Wheeler) founded a company called IG Index in 1974 to provide gold spread betting. At the time, the gold market was very difficult for many people to participate, and spread betting provided a simpler way to speculate.

Although originated in the United States, spread betting is illegal in the United States.

Stock market trading and spread betting

Let us use a practical example to illustrate the pros and cons of this derivatives market and the betting mechanism. First, we will take the stock market as an example, and then we will study the equivalent spread bet.

For our stock market transactions, suppose that 1,000 shares of Vodafone (London Stock Exchange ticker symbol: VOD) were purchased at a price of £193.00. The price rose to 195.00 pounds, the position was closed, the gross profit was 2,000 pounds, and the earnings per share for 1,000 shares was 2 pounds. Please note a few important points here. If margin is not used, this transaction will require a substantial capital expenditure of £193,000. In addition, commissions are usually charged to enter and exit stock market transactions. Finally, profits may be subject to capital gains tax and stamp duty.

Now, let’s look at a comparable spread bet. To place a spread bet on Vodafone, we assume that you can buy the bet at a price of £193.00 through the bid-ask spread. When making this kind of spread bet, the next step is to decide how much to invest per “point”, which is a variable that reflects price changes. The value of a point may be different.

In this case, we will assume that Vodaphone’s stock price rises or falls by 1 point equals 1 penny. Let’s now assume that we are buying or “raising” on Vodaphone at a price of £10 per point. Vodaphone’s share price rose from 193.00 pounds to 195.00 pounds, as in the stock market example. In this case, the bet received 200 points, which means that the profit is 200 x 10 GBP or 2,000 GBP.

Although the gross profit of 2,000 pounds in the two examples is the same, the difference between spread bets is that there is usually no commission for opening or closing positions, and no stamp duty or capital gains tax is required. In the UK and some other European countries, spread betting profits are tax-free.

However, although spread traders do not pay commissions, they may be affected by the bid-ask spread, which may be much larger than the spread in other markets. Remember also that bettors must overcome the spread to break even in the transaction. Generally speaking, the more popular the securities being traded, the smaller the spread, thereby reducing the cost of entry.

In addition to no commissions and taxes, another major benefit of spread betting is that the required capital expenditure is greatly reduced. In stock market transactions, deposits of up to £193,000 may be required to enter the transaction. In spread betting, the required deposit amount varies, but for this example, we will assume the required 5% deposit. This means that fewer deposits of £9,650 are required to bear the same amount of market risk as stock market transactions.

Of course, the use of leverage is two-way, and this is where the danger of spread betting lies. As the market benefits you, higher returns will be achieved; on the other hand, as the market turns against you, you will suffer greater losses. Although you can make a lot of money quickly with a relatively small deposit, you can also lose money at the same rate.

If the price of Vodaphone in the above example drops, the bettor may eventually be asked to increase the deposit, and may even automatically close the position. In this case, the advantage of stock market traders is that if they still believe that prices will eventually rise, they can wait for the market to fall.

Risk management in spread betting

Although the use of high leverage can bring risks, spread betting provides effective tools to limit losses.

  • Standard stop loss order: Once the market exceeds the set price level, stop-loss orders reduce risk by automatically closing losing trades. In the case of a standard stop loss, once the set stop loss value is reached, the order will close your trade at the best available price. Your trade may be closed at a level worse than stop loss triggering, especially when the market is in a state of high volatility.
  • Guaranteed stop loss order: Regardless of the potential market conditions, this form of stop loss order can guarantee the end of your transaction at the exact value you set. However, this form of downside insurance is not free. Guaranteed stop-loss orders usually charge additional fees to your broker.

Risk can also be reduced by using arbitrage, betting in two ways at the same time.

Spread betting arbitrage

When the price of the same financial instrument is different in different markets or between different companies, arbitrage opportunities will appear. Therefore, financial instruments can be bought low and sold high at the same time. Arbitrage trading uses these market inefficiencies to obtain risk-free returns.

Due to the increased availability of information and increased exchanges, arbitrage opportunities for spread betting and other financial instruments have been restricted. However, when the two companies take different positions in the market when setting their own spreads, spread betting arbitrage may still occur.

At the expense of market makers, arbitrageurs bet on the spread between two different companies. When the top of the spread provided by one company is lower than the bottom of the spread of another company, arbitrageurs profit from the gap between the two. In short, traders buy low from one company and sell high at another company. Whether the market rises or falls does not determine the return.

There are many different types of arbitrage, allowing the use of differences in interest rates, currencies, bonds and stocks, and other securities. Although arbitrage is usually associated with risk-free profits, there are actually risks associated with this practice, including execution, counterparty, and liquidity risks. Failure to complete the transaction successfully may cause significant losses to arbitrageurs. Similarly, counterparty and liquidity risks may come from the market or the company’s failure to complete the transaction.

Bottom line

With the emergence of the electronic market, spread trading continues to develop and mature, successfully lowering the barriers to entry, and creating a broad and diverse alternative market.

Especially for arbitrage, investors can take advantage of the price difference between two markets, especially when two companies offer different price differences for the same asset.

The temptation and danger of over-leveraged is still the main trap of spread betting. However, the required low capital expenditures, available risk management tools and tax incentives make spread betting an attractive opportunity for speculators.

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