Spread betting is a derivative strategy, where participants do not actually own the underlying asset they bet on, such as a stock or commodity. Rather, spread bettors simply speculate on whether the asset's price will rise or fall, using the prices offered to them by a broker.

As in stock market trading, two prices are quoted for spread bets – a price at which you can buy, aka the bid price, and a price at which you can sell, aka the ask price. The difference between the buy price and sell price is referred to as the spread. The spread-betting broker profits from this spread, and this allows spread bets to be made without commissions, unlike most securities trades.

Investors align with the bid price if they believe the market will rise and go with the ask if they believe it will fall. Key characteristics of spread betting include the use of leverage, the ability to go both long and short, the wide variety of markets available and tax benefits.

Origins of Spread Betting

If spread betting sounds like something you might do in a sports bar, you're not far off. Charles K. McNeil, a mathematics teacher who became a securities analyst – and later a bookmaker – in Chicago during the 1940s has been widely credited with inventing the spread-betting concept. But its origins as an activity for professional financial-industry traders happened roughly 30 years later, on the other side of the Atlantic. A City of London investment banker, Stuart Wheeler, founded a firm named IG Index in 1974, offering spread betting on gold. At the time, the gold market was prohibitively difficult to participate in for many, and spread betting provided an easier way to speculate on it.

Ironically, despite its American roots, spread betting is not currently legal in the United States.

A Stock Market Trade vs. a Spread Bet

Let's use a practical example to illustrate the pros and cons of this derivative market and the mechanics of placing a bet. First we'll take an example in the stock market, and then we'll look at an equivalent spread bet.

For our stock market trade, let's assume a purchase of 1,000 shares of Vodafone (LSE:VOD) at £193.00. The price goes up to £195.00 and the position is closed, capturing a gross profit of £2,000, having made £2 per share on 1,000 shares. Note here several important points. Without the use of margin, this transaction would have required a large capital outlay of £193k. Also, normally commissions would be charged to enter and exit the stock market trade. Finally, the profit may be subject to capital gains tax and stamp duty.

Now, let's look at a comparable spread bet. Making a spread bet on Vodafone, we'll assume with the bid offer spread, you can buy the bet at £193.00. In making this spread bet, the next step is to decide what amount to commit per "point", the variable that reflects the price move. The value of a point can vary. In this case we will assume that one point equals a one pence change up or down in the Vodaphone share price. We'll now assume a buy or "up bet" is taken on Vodaphone at a value of £10 per point. The share price of Vodaphone rises from £193.00 to £195.00, as in the stock market example. In this case the bet captured 200 points, meaning a profit of 200 x £10, or £2,000.

While the gross profit of £2,000 is the same in the two examples, the spread bet differs in that there are usually no commissions incurred to open or close the bet and no stamp duty or capital gains tax due. In the U.K. and some other European countries, the profit from spread betting is free from tax.

However, while spread bettors do not pay commissions, they may suffer from the bid offer spread, which may be substantially wider than the spread in other markets. Keep in mind also that the bettor has to overcome the spread just to break even on a trade. Generally, the more popular the security traded, the tighter the spread, lowering the entry cost.

In addition to the absence of commissions and taxes, the other major benefit of spread betting is that the required capital outlay is dramatically lower. In the stock market trade, a deposit of as much as £193,000 may have been required to enter the trade. In spread betting, the required deposit amount varies, but for the purpose of this example we will assume a required 5% deposit. This would have meant that a much smaller £9,650 deposit was required to take on the same amount of market exposure as in the stock market trade.

The use of leverage works both ways, of course, and herein lies the danger of spread betting. As the market moves in your favor, higher returns will be realized; on the other hand, as the market moves against you will incur greater losses. While you can quickly make a large amount of money on a relatively small deposit, you can lose it just as fast.

If the price of Vodaphone fell in the above example, the bettor may eventually have been asked to increase the deposit or even have had the position closed out automatically. In such a situation, stock market traders have the advantage of being able to wait out a down move in the market, if they still believe price is eventually heading higher.

Managing Risk in Spread Betting

Despite the risk that comes with the use of high leverage, spread betting offers effective tools to limit losses.

  • Standard Stop Loss Orders - Stop loss orders reduce risk by automatically closing out a losing trade once a market passes a set price level. In the case of a standard stop loss, the order will close out your trade at the best available price once the set stop value has been reached. It's possible that your trade can be closed out at a worse level than that of the stop trigger, especially when the market is in a state of high volatility.
  • Guaranteed Stop Loss Orders - This form of stop loss order guarantees to close your trade at the exact value you have set, regardless of the underlying market conditions. However, this form of downside insurance is not free. Guaranteed stop loss orders typically incur an additional charge from your broker.

Risk can also be mitigated by the use of arbitrage – betting two ways simultaneously.

Spread Betting Arbitrage

Arbitrage opportunities arise when the prices of identical financial instruments vary in different markets or among different companies. As a result, the financial instrument can be bought low and sold high simultaneously. An arbitrage transaction takes advantage of these market inefficiencies to gain risk-free returns.

Due to widespread access of information and increased communication, opportunities for arbitrage in spread betting and other financial instruments have been limited. However, spread betting arbitrage can still occur when two companies take separate stances on the market while setting their own spreads.

At the expense of the market maker, an arbitrageur bets on spreads from two different companies. When the top end of a spread offered by one company is below the bottom end of another’s spread, the arbitrageur profits from the gap between the two. Simply put, the trader buys low from one company and sells high in another. Whether the market increases or decreases does not dictate the amount of return.

Many different types of arbitrage exist, allowing for the exploitation of differences in interest rates, currencies, bonds and stocks, among other securities. While arbitrage is typically associated with risk-less profit, there are in fact risks associated with the practice, including execution, counterparty and liquidity risks. Failure to complete transactions smoothly can lead to significant losses for the arbitrageur. Likewise, counterparty and liquidity risks can come from the markets or a company’s failure to fulfill a transaction.

The Bottom Line

Continually developing in sophistication with the advent of electronic markets, spread betting has successfully lowered the barriers to entry and created a vast and varied alternative marketplace.

Arbitrage, in particular, lets investors exploit the difference in prices between two markets – specifically, when two companies offer different spreads on identical assets.

The temptation and perils of being overleveraged continue to be a major pitfall in spread betting. However, the low capital outlay necessary, risk management tools available and tax benefits make spread betting a compelling opportunity for speculators.

See also Want to Day Trade? Try Binary Options Or Spread Betting.

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