How Spread Betting Works

Spread betting is a form of derivative trading that involves speculating on the direction of a financial market without taking ownership of the underlying asset. The term “spread betting” gets its name from the spread, which is the difference between the buy and sell prices. You can use leverage, so you only need to provide a small deposit (margin) instead of paying the full value of your position. Read on to learn how spread betting works.

Speculating on price movement

Spread betting (also known as financial spread betting or FSB) allows investors to speculate on the price movement of a wide range of financial instruments (such as shares, indices, currency pairs or commodities).

Mechanics of spread betting

Unlike traditional trading, spread betting operates through bets rather than the physical buying and selling of assets. So, you make a bet based on whether the price of the market is likely to rise or fall.

For instance, in a traditional trade you would buy Apple stock, hold it and then sell it. In spread betting, you achieve the same outcome by betting that Apple’s share price will increase. The further that Apple’s price moves in your chosen direction, the more profit you make. However, the further it moves against you, the bigger your loss.

Spread-betting companies offer buy and sell prices to potential investors, allowing them to place investments based on their market prediction. Investors use the buy price if they expect the market will rise, or the sell price if they expect it to fall. Unlike traditional investing, spread betting is a form of betting. However, unlike fixed-odds betting, it does not depend on a specific event happening.

You can close the bet at any time to secure profits or limit losses. Financial Spread Betting (FSB) is a margined derivative product that allows you to bet on the price movements of various financial markets and products, including stocks, bonds, indices, currencies, etc. Investors can take into long or short positions based on their predictions of market direction.

What is the spread?

The spread is the difference between the buy and sell prices listed on a market and represents the cost of opening a spread betting position. Instead of paying a commission, all trading costs are included in this spread.

Bet sizes

Another key aspect of spread betting is your bet size. Choosing a bet size allows you to decide how many pounds per point to allocate to each trade, determining your profit or loss for every point the market moves.

When spread betting, your bet will be in pounds per point. For example, if you bet £5 per point that Apple stock will rise, you’ll earn £5 for every point it goes up. But for every point it falls, you’ll lose £5.

Going long and going short

Unlike traditional share investment, spread betting allows you to sell a market if you think its value will decrease. This is known as ‘going short’. On the other hand, if you think the value of an asset will increase, you ‘go long’ which means you will buy.

When you open a spread bet, there are two prices listed, the buy price and the sell price. You can go long or short. If you think the price of your chosen market will go up, you click ‘Buy’. If you think it will fall, you click ‘Sell’.

To close a spread bet, you need to trade in the opposite direction from when you opened it. So, if you initially bought, you would sell to close, and vice-versa.

Spread betting example – Buying oil

If you think that the price of oil will rise, you can place a buy trade with a stake of £2 a point.

For every point the price of oil rises, you earn £2. On the other hand, if the price falls, you lose £2 for each point of downward movement.

Your profit or loss is realised when you close your position. For instance, if the price of oil increases by 50 points from your entry, you would make £100 (50 points x £2). If it decreases by 50 points, you would lose £100.

Going short – Selling Tesco

Tesco is trading at 279 and you believe that the share price will fall, so you go short at £5 per point at 279.

Tesco announces it overestimated its pre-tax profits for the last six months by £250m. As a result, Tesco’s share price plunges to 218p as shareholders lose confidence. You decide to close your trade at this new price.

Since Tesco’s stock has fallen by 61 points (from 279 to 218), your spread bet earns you £5 for each point of downward movement. Therefore, your profit would be £305 (61 x 5).

Conversely, if Tesco’s stock had risen by 61 points instead of falling, you would have incurred a loss of £305. Note that this example does not account for any overnight financing charges that might apply.

Leverage and margin in spread betting

Leverage

Leverage is an important aspect of spread betting. Leverage allows traders to manage larger positions with a smaller initial investment. For instance, when trading stocks, you might only need to deposit 20% of the total position value. This represents leverage of 1:5. In markets like forex, leverage ratios of 1:20 or more are common.

It’s important to note that while leverage can amplify profits, it also increases potential losses. Therefore, you need to use effective risk management strategies when using leverage in spread betting.

Margin

Margin is the amount of funds that must be maintained in a trader’s account to keep a leveraged position open in spread betting. When trading with leverage, you need to make sure that you always have enough margin in your account.

For instance, if you intend to bet £10 per point on the FTSE 100 when it is trading at 7,500, with leverage of 1:20, the total position size would be £75,000 (10 x 7500). To open this position, you would need to deposit £3,750 as margin, which is 5% of the total position value (£75,000). Make sure your account always has at least 5% of the position’s full value to keep it active.

Managing positions and risk

Effective risk management is essential in spread betting. This involves carefully considering the potential risks and implementing strategies to mitigate them. This involves creating a risk management plan to address the unique challenges of each trade.

 An essential tool for risk management is the use of stop losses. By placing a stop loss order, you instruct your spread betting provider to automatically close a position if the market moves a specified distance against you. This helps limit risk by setting the maximum acceptable loss for each trade.

Spread betting is favoured for several reasons

1. Commission free: There are no charges for commission on spread bets.
2. Leveraged: Allows traders to control larger trades with a smaller initial deposit.
3. Flexible: Allows trading on falling markets (going short) as well as rising markets (going long).

Additionally, retail traders get negative balance protection, ensuring they can’t lose more than they deposit.

Who is spread betting suitable for?

Spread betting may be ideal for investors looking for the opportunity to make a better return for their money. However, it involves significant risks to your capital and may not be suitable for everyone. It’s advisable to practice trading on a demo account before you try spread betting on live markets. Spread betting appeals to individuals who want:

• Short-term trading opportunities : Spread bets are typically held for a few days or weeks, making it suitable for traders focused on the shorter term rather than over the longer term.
• To diversify their portfolio: There are 1,000s of spread betting markets to speculate on including shares, commodities, FX and indices,
• Flexibility in trading frequency: You can trade multiple times a day, or open just a few positions each quarter. Spread betting accommodates both active and passive trading preferences.

In summary

Spread betting is a flexible derivative trading method allowing investors to speculate on financial market movements without owning underlying assets. With its leverage, flexibility, and diverse market options, spread betting offers opportunities for both short-term and strategic traders, accompanied by essential risk management practices to protect investments.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.