Published by Filipe R. Costa on Tue, 15/03/2011 — 12:03

Spread betting is a way of assuming a position in financial markets. A leveraged bet, similar to margin trading.

When you want to buy shares, you go to your stockbroker or to your online trading platform, and choose the shares you want to deal. You are then presented with two prices, one lower and another higher. Basically you get a bid and an ask prices. If you want to buy, you get the ask price, the higher one. If you want to sell, you face the bid price, the lower one. The difference between bid and ask prices is called the spread. And it is from that difference, that spread betting derives its name.

When you want to trade shares you have to decide the quantity you want to buy or sell. You can buy 10, 100, or maybe 1,000 shares of some company. That number multiplied by the ask price, gives you the total amount you have to invest. In spread betting things are a little different. You buy or sell at the bid and ask prices like it happens in traditional trading. But you don’t have to decide on quantity but rather on stake per point. You are betting some amount per point or penny change. You don’t exactly hold shares. You are just betting on price movements. The effect is the same and the final outcome has some advantages avoiding you some tax and fee payments, which we will discuss in a later article.

Another important point to take into consideration is the total amount invested. When trading shares you need an amount equal to the ask price times the quantity of shares. The same position can be achieved in spread betting by putting aside just 10, 5 or even just 1% of the total amount you need for your investment. Spread betting is a kind of margin trading, or at least similar to it. It’s a leveraged product. Leverage is good for you, freeing up some funds you can apply elsewhere but it also involves additional risks that you should know beforehand. A margin call can sometimes happen, meaning that you can have to put more funds into your account, and it can happen that you lose more than you have on it. This possibility has to be weighted but not overstated. Many people say that spread betting is risky because you can lose more than you have. That is theoretically true but very unlikely to happen. Before happening such a thing, your spread betting company would start selling your positions to avoid such a loss, like it happens with margin trading on a traditional stockbroker. I think the major problem of leveraged products is related to a person losing more than he first thought possible rather than more than what he has.

But let’s return to the main matter and see how spread betting works. Suppose we want to trade Vodafone, and that the company is trading shares at 169.90 – 170.10. You see two prices: bid at 169.90, and ask at 170.10.

Traditional Transaction

If we decide to buy Vodafone shares in the traditional way, we first decide on the quantity. Let’s say we want 1,000 shares. We need 1000 times 170.10 or 170,100 pennies. Translating to pounds we have £1,701 of total investment.

Spread Betting

Rather than buying 1,000 shares, we decide to bet on the spread. If our spread betting company presents trading on Vodafone as bet per point, we will bet £10 per point. Betting such an amount is the same as holding £1,701 in Vodafone shares. Theoretically the maximum loss is when Vodafone goes into bankruptcy and is valued at zero. You would lose £1,701. The potential loss is the same as for the traditional case. Spread betting companies only require you a margin of 5 or 10% to carry this bet. It means that you only need something between £85.05 and £170.10, instead of the full amount.

So, basically, spread betting gives us the opportunity to assume a position that is similar to what we can do using traditional stockbroking. We just need less money. And you can easily see that. If the spread betting company only requires you 5% of the total amount, it means that if your bet goes against you by 5%, your funds will disappear, in the case you just have that margin in your account. People tend to use the margin until infinity amplifying too much their potential loss. But if you strategically and methodically use it, you will be better off than with traditional stockbroking.