Many investors wonder how financial spread-betting companies make money when they don’t charge brokerage on bets placed. IG Group Holdings PLC (OTC: IGGHY), a spread-betting company in the United Kingdom, reported GBP £569 million ($751.2 million) from global trading revenue in the 2018 financial year. How do these companies generate a profit? And how does a trader select the right broker? Following is a look at how financial spread-betting companies create revenue.
Revenue From the Spread
First and foremost, spread-betting companies make revenue through the spreads they charge clients to trade. In addition to the usual market spread, the broker typically adds a small margin, meaning that a stock normally quoted at $100 to buy and $101 to sell, may be quoted $99 to sell and $102 to buy in a spread bet. The buy price is always higher than the sell price, ensuring the broker makes a profit from the spread, whether the client wins or loses.
The A Book and the B Book
Brokers categorize clients into their A or B books. Traders who have a track record of losing money are placed into the broker's B book. Bets from B-book clients are not sent to the market; instead, the company actively bets against them. In this scenario, the broker stands to win when the client loses, and vice versa. Given that 90% of traders lose their deposits within six months, this model has proven to be extremely profitable.
There is, however, some risk involved with backing B-book clients. Spread-betting companies have risk limits, and if too many clients bet in one direction, these limits are breached. Brokers must then hedge their bets to restore risk to an acceptable level. Brokers avoid hedging B-book clients unless absolutely necessary, because they are effectively paying for another spread, increasing bottom line costs.
A-book clients are a similarly dependable stream of revenue, and provide opportunities to capture commissions. They trade large enough that risk is substantially lower than B-book clients, and they often enjoy a relationship in which they are trusted to expose the market (and not the broker) to risk. Such clients are often charged a premium on the standard spread, or a specially negotiated fee.
Associated Trading Costs
Spread-betting companies allow their clients to continue trading throughout the global trading day, which is from the Asian session open to the New York session close, Monday to Friday. The flipside is that spread-betting companies typically charge a holding fee to carry a position overnight. Beginners often get distracted by an attractive spread and miss these ongoing trading costs, which in time are likely to erode profits. It is therefore in the best interests of the broker to keep clients holding positions as long as possible, as they stand to generate more revenue from associated fees.
Spread-betting companies are subject to strict regulations worldwide. The European Securities and Markets Authority (ESMA), for example, has passed and enforced regulations that limit certain types of financial betting. In late 2018, ESMA upheld a ban on the sale of binary options to retail customers, which may change some investors' interest in spread-betting companies.
Finding the Right Broker
Spread-betting companies obviously make a lot of money, but how can a beginner get involved? The first step is choosing the right broker, sometimes a misstep for overeager traders who often squander their initial deposits. The markets may move against a trader, but more often than not, it is the choice of broker that determines overall success. Does the client bet on commodities or interest rates? How important is customer support? Which broker has the lowest spreads? These are important concerns when considering which spread-betting company to choose.
Taking advantage of online spread-betting comparison resources, using price comparison tools and keeping a level head means that a trader can feasibly share in the wealth that spread-betting companies have created.