What is Spread Betting?

Spread betting involves speculating on the price direction of an underlying instrument without actually owning the asset. This involves placing a bet on whether the price movement of a security will rise or fall. A spread betting company provides two prices, the bid and ask prices and investors bet on whether the price of the underlying security will be lower than the bid or higher than the ask.

History of spread betting

Charles K. McNeil, a mathematics teacher who became a securities analyst and later a bookmaker in Chicago during the 1940s is widely credited with inventing the concept of spread-betting. However, its origins as an activity for professional financial-industry traders happened around 30 years later. In 1974, City of London investment banker Stuart Wheeler founded IG Index, a company that offered spread betting on gold. The gold market was difficult for many to access at the time, and spread betting provided an easier way to speculate on it.

How spread betting works

Spread betting allows you to speculate on the price movement of various financial instruments, such as stocks, indices, commodities, and currencies. It involves two quoted prices, a bid price (buy) and an ask price (sell). The difference between these prices is known as the spread.

The broker profits from this spread, allowing trades to be made without commissions, unlike most securities trades. Basically, you buy at the bid price if you think the market will rise and sell at the ask price if you think it will fall. Also is a tax-free, commission-free activity that allows investors to profit in both bull and bear markets.

Spread betting is a leveraged product. This means you only need to deposit a small percentage of the position’s value. For example, if a position is valued at $50,000 and the margin requirement is 10%, only a $5,000 deposit is necessary. This leverage magnifies both gains and losses, allowing investors to potentially gain or lose more than their initial investment.

Managing risk in spread betting

Despite the risk associated with high leverage, spread betting offers effective tools to limit losses:

Standard stop-loss orders: Stop-loss orders automatically close out a losing trade once the market reaches a set price level, reducing risk. With a standard stop-loss, the trade is closed at the best available price once the stop value is reached. However, in highly volatile markets, the trade may be closed at a worse level than the stop trigger.

Guaranteed stop-loss orders: This type of stop-loss order ensures that your trade is closed at the exact price you set, regardless of market conditions. However, this form of downside protection typically incurs an additional charge from your broker.

Arbitrage

Risk can also be mitigated through arbitrage, which involves betting two ways simultaneously.

Arbitrage opportunities arise when identical financial instruments are priced differently in various markets or by different companies. This allows investors to buy low and sell high simultaneously. By using arbitrage, you can achieve risk-free returns.

An arbitrageur profits at the expense of the market maker by betting on spreads from two different companies. When the top end of one company’s spread is below the bottom end of another’s, the arbitrageur can profit from the difference. In other words, the trader buys low from one company and sells high to another. The market’s direction does not affect the amount of return.

There are various types of arbitrage, such as those involving differences in interest rates, currencies, bonds, and stocks. Although arbitrage is generally seen as a way to achieve risk-free profit, it carries its own risks, including execution, counterparty, and liquidity risks. Not completely transactions smoothly can lead to significant losses, while counterparty and liquidity risks may arise from market conditions or a company’s inability to fulfil a transaction.

Upsides of spread betting

Going long/short

You can speculate on both upward and downward price movements. Unlike trading physical shares, where selling requires borrowing stocks (which can be time-consuming and costly), spread betting makes short selling as easy as buying.

No commissions

Spread betting companies generate revenue from the spread they offer. There are no additional commission charges, making it easier to monitor trading costs and calculate position sizes.

Tax benefits

In certain tax jurisdictions, spread betting is considered gambling. Consequently, any realised profits may be subject to taxation as winnings rather than capital gains or income. If you participate in you should keep records and consult an accountant before completing your taxes.

Limitations of spread betting

Margin calls

Investors who are not familiar with leverage may take positions that exceed their account balance, which can result in margin calls. They should limit their risk to no more than 2% of their investment capital (deposit) per trade and carefully consider the position value of each bet they intend to open.

Wide spreads

During periods of volatility, spread betting firms may widen their spreads. This can activate stop-loss orders and increase trading costs. Investors should be cautious when placing orders shortly before company earnings announcements and economic reports.

Spread betting vs. CFDs

Many spread betting platforms also provide trading in CFDs (contracts for difference), which are a similar type of contract. CFDs are derivative contracts, allowing traders to speculate on short-term price movements. CFDs do not involve delivery of physical goods or securities.

However, the contract holds transferrable value throughout its duration. A CFD represents a tradable security formed between a client and a CFD broker, where they exchange the difference between the initial trade price and its value on closure or reversal of the trade.

While CFDs allow investors to trade the price movements of futures, they differ from futures contracts. CFDs do not have expiration dates with pre-determined prices. Instead, they trade similarly to other securities with buy and sell prices.

On the other hand, spread bets have fixed expiration dates when the bet is initially placed. CFD trading requires upfront payment of commissions and transaction fees to the provider; however, spread betting companies do not charge fees or commissions.

When the contract is closed and profits or losses are realised, you either receive money owed or owe money to the broker. If profits are realised, you calculate the net the profit of the closing position, subtracting the opening position and fees. Profits for spread bets, on the other hand, are determined by the change in basis points multiplied by the initial bet amount in dollars.

Both CFDs and spread bets involve dividend payouts when holding a long position contract. While you do not own the asset directly, both providers and spread betting companies will pay dividends if the underlying asset performs well. For CFD trades, profits are subject to capital gains tax, whereas profits from spread betting are usually tax-free.

Is spread betting gambling?

Spread betting can be used to speculate with leverage, but it can also be used to hedge existing positions or make informed directional trades. Many who participate prefer the term “spread trading”. From a regulatory and tax perspective, spread betting may be considered as a form of gambling in certain jurisdictions. This is because no actual position is taken in the underlying instrument.

In summary

Spread betting involves speculating or betting on the direction a financial market, without owning the underlying security. Instead of owning the asset, you speculate on the expected price movement of the security. A spread betting company provides both the bid and ask prices, and you bet on whether the security’s price will fall below the bid or go above the ask price.

With continuous development in electronic markets, spread betting has become more sophisticated, lowering entry barriers for some investors and creating a diverse alternative marketplace.

Arbitrage allows you to capitalise on price differences between two markets, especially when two companies offer different spreads on identical assets.

While high leverage is a risk in spread betting, the low initial capital requirement, available risk management tools, and tax benefits make spread betting an attractive option for speculators.

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.