Spread betting is a derivative technique in which players do not own the underlying asset, such as a stock or commodity, on which they bet. Spread bettors, on the other hand, simply guess on whether the asset’s price will grow or decrease, using the prices given by a broker.
For spread bets, two prices are stated, much as in stock market trading: a price at which you may buy (bid price) and a price at which you can sell (call price) (ask price).The spread is the difference between the purchase and sell prices. This spread enriches the spread-betting broker, allowing spread bets to be placed without fees, unlike typical securities deals.
If investors feel the market will increase, they will align with the bid price; if they believe the market will fall, they will align with the ask price. Spread betting’s key qualities include the use of leverage, the ability to go both long and short, the large range of markets accessible, and tax advantages.
- Spread betting enables traders to speculate on the direction of a financial market without owning the underlying asset.
- Spread betting is sometimes marketed as a tax-free, commission-free activity that enables investors to speculate in both bull and bear markets, but it is still illegal in the United States.
- Spread bet risks, like stock trading risks, may be minimized by utilizing stop loss and take profit orders.
Origins of Spread Betting
You’re not far off if spread betting seems like something you’d do at a sports bar. Charles K. McNeil, a mathematics instructor who became a securities analyst—and ultimately a bookmaker—in Chicago during the 1940s, is largely credited with developing spread betting. However, its roots as a professional financial-industry trading activity occurred around 30 years later, on the opposite side of the Atlantic. Stuart Wheeler, a City of London financial banker, created IG Index in 1974, providing gold spread betting. The gold market was prohibitively difficult for people to engage in at the time, and spread betting gave an easier method to speculate on it.
Spread betting, despite its American origins, is forbidden in the United States.
A Stock Market Trade Versusa Spread Bet
Let us use a practical example to demonstrate the benefits and drawbacks of this derivative market as well as the mechanics of making a bet. First, we’ll look at a stock market example, followed by an identical spread bet.
Assume a £193.00 purchase of 1,000 Vodafone (LSE: VOD) shares for our stock market deal. The price rises to £195.00, and the trade is closed, resulting in a £2,000 gross profit and a profit of £2 per share on 1,000 shares. Several essential things should be highlighted here. This deal would have needed a substantial capital investment of £193k if margin had not been used. In addition, commissions would generally be levied to join and leave the stock market deal. Finally, capital gains tax and stamp duty may be levied on the profit.
Now consider an equivalent spread bet. When placing a spread bet on Vodafone, we’ll suppose that the bid-offer spread allows you to purchase the bet for £193.00. The next stage in placing this spread bet is deciding how much to commit per “point,” the variable that measures the price movement. A point’s value may change.
In this scenario, we will suppose that one point represents a one penny movement in the Vodaphone share price, either up or down. We’ll now suppose that a £10 per point purchase or “up bet” is placed on Vodaphone. As in the stock market example, the share price of Vodaphone climbs from £193.00 to £195.00. In this scenario, the bet won 200 points, resulting in a profit of 200 times £10, or £2,000.
While the total profit in both scenarios is £2,000, the spread bet differs in that there are normally no fees required to initiate or terminate the bet, as well as no stamp duty or capital gains tax payable. Spread betting profits are tax-free in the United Kingdom and certain other European nations.
While spread bettors do not pay fees, they may be affected by the bid-offer spread, which may be much greater than in other markets. Remember that the bettor must overcome the spread in order to break even on a transaction. In general, the narrower the spread, the lower the entry cost, the more popular the securities exchanged.
Aside from the lack of fees and taxes, another significant advantage of spread betting is the much lower necessary initial investment. A deposit of up to £193,000 may have been needed to join the stock market deal. The needed deposit amount varies in spread betting, but for the sake of this example, we will assume a 5% deposit is required. This would have needed a significantly lower £9,650 commitment to take on the same level of market exposure as in the stock market deal.
Of course, leverage goes both ways, and here is where spread betting may go wrong. Higher profits will be obtained when the market swings in your favor; but, if the market goes against you, you will suffer bigger losses. While you may rapidly gain a significant amount of money with a tiny investment, you can also lose it just as quickly.
If the price of Vodaphone fell in the preceding example, the bettor might have been asked to increase the deposit or even have the position automatically closed out. In such a case, stock market traders have the benefit of being able to ride out a market downturn if they still feel the price will ultimately rise.
Managing Risk in SpreadBetting
Despite the danger associated with using large leverage, spread betting provides useful methods for limiting losses.
- Stop-loss orders: Stop-loss orders limit risk by automatically closing out a losing transaction when the market reaches a certain price level. When a normal stop-loss order is used, the order will close out your transaction at the best available price after the designated stop value is achieved. It’s conceivable that your transaction will be closed out at a lower level than the stop trigger, particularly if the market is volatile.
- Guaranteed stop-loss orders: This kind of stop-loss order assures that your transaction will be closed at the precise value you choose, regardless of underlying market circumstances. However, this kind of downside protection is not free. Your broker will usually charge you more for guaranteed stop-loss orders.
Risk may also be reduced by using arbitrage, which involves betting in two directions at the same time.
Spread Betting Arbitrage
When the pricing of similar financial instruments diverge in various markets or across different organizations, arbitrage possibilities develop. As a consequence, the financial instrument may be purchased cheap and sold high at the same time. An arbitrage transaction exploits market inefficiencies to generate risk-free rewards.
Because of greater communication and broad access to information, prospects for arbitrage in spread betting and other financial instruments have been curtailed. Spread betting arbitrage may still occur when two organizations take opposing positions in the market and create their own spreads.
An arbitrageur wagers on spreads from two distinct corporations at the cost of the market maker. When the top end of one company’s spread is lower than the bottom end of another’s spread, the arbitrageur benefits on the difference. To put it simply, the trader buys cheap from one business and sells high from another. The amount of return is unaffected by whether the market rises or falls.
There are several varieties of arbitrage, which enable the exploitation of disparities in interest rates, currencies, bonds, and stocks, among other instruments. While arbitrage is often linked with risk-free profit, it does include risks such as execution, counterparty, and liquidity concerns. Failure to execute deals in a timely manner might result in severe losses for the arbitrageur. Similarly, counterparty and liquidity risks may arise from market volatility or a company’s inability to complete a deal.
The Bottom Line
Spread betting has effectively decreased the obstacles to entry and developed a huge and diverse alternative marketplace as it has grown in complexity with the introduction of electronic marketplaces.
Arbitrage, in example, allows investors to profit on pricing differences between two marketplaces, such as when two businesses provide different spreads on similar assets.
The temptation and dangers of being overleveraged remain big pitfalls in spread betting. Spread betting, on the other hand, is an appealing possibility for speculators because to the modest initial outlay required, risk management techniques accessible, and tax advantages.
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