One of the derivative strategies that speculative investors can use to generate money is known as spread betting. Through spread better, you can bet on whether the price of a particular asset, such as a stock or a commodity, will rise or fall. You do not need to own the underlying asset to engage in spread betting and instead are merely speculating on the direction a particular investment will go.
Brokers will offer two prices for spread bets: the bid price (low) and the ask price (high). The difference between these two prices is known as the spread. If you select the bid price, this means you believe the price of the asset will rise. Conversely, aligning with the ask price means you think the value of the asset will fall. Brokers profit significantly from spread betting. This means you can place bets without paying a commission, which is not the case with most securities transactions.
Because this is such a fringe investment (it is not even legal in the US), it is important to understand spread betting before you engage in it yourself. Here are three of the most important things you need to know about spread betting:
1. An Example of Spread Betting on the Stock Market
Because spread betting is complicated, the best way to get a handle on it is to look at a practical example and see the mechanics in action. First, let’s imagine a stock market transaction. You purchase 100 shares of Company X at $200 per share. The price of Company X stock closes at $205 per share. Thus, you have a gross profit of $500 on your purchase.
In this example, however, note that you would need to pay commissions to enter and exit the market, which would eat into profits. Also, you may need to pay capital gains tax on the amount that you earn on the trade. Furthermore, you would need a lot of capital to put down unless you have margin for trade. The entire trade would cost $20,000 outside of the fees and taxes, so for many people, such a purchase would not be feasible.
Now imagine the same scenario as a spread bet. You can buy shares of Company X at $200. The next step in the process is deciding on a point value. A point is the minimum amount of movement in price and asset may make. Often, one point is one cent. Imagine that you take a buy or “up bet” on Company X at a value of $10 per point. If the stock increases to $205, then you just made $5,000 ($10 per point x 500 points/cents = $5,000).
Spread betting makes it possible to profit without as large of an upfront investment. Furthermore, you will not need to pay any commissions and might not even owe taxes, depending on your jurisdiction. In addition, you were not required to put down any money to make this gain, unlike in the stock example that required thousands of dollars upfront. Of course, brokers usually require a deposit, but it is usually about 5 percent or so of the possible payout, which is much less than you would need to purchase the stock.
2. The Major Risk Involved with Spread Betting
Since much spread betting occurs on leverage, it is possible to make a lot of money with relatively little capital, as in the example above. However, the potential for major returns also means that you could experience major losses. In the example above, the cost of Company X stock could have fallen to $195, in which case you would owe $5,000. And because the broker sets the spread, you do not have a choice in how much it is possible to oh.
When the market moves against you, the fallout can be catastrophic. When you are earning money, brokers are happy to continue working on leverage because they know that the odds are you will end up experiencing a major loss eventually. However, if you are in the red, brokers will not let you continue bettering until you pay. This means you never have the chance to earn money back, so you need to be prepared to lose when you spread bet.
To reduce risk in spread betting, speculators can employ a couple of tools, such as a stop-loss order. This order will automatically close out a losing trade once the market passes a set price level. With a standard stop-loss order, the position gets closed at the best available price for the set stop value. Thus, it is possible that your trade can be closed out at a worse level than that of the stop trigger if the market is in a volatile state. In other words, this is not a guaranteed protection.
You may also opt for a guaranteed stop-loss order, which guarantees the close of a position at the exact value you set regardless of market conditions. You can think of this sort of like the ability to set your own spread rather than settling for what the broker offers. However, this type of insurance is not free and will limit your earnings. Some speculators mitigate risk through arbitrage.
3. Arbitrage as a Strategy for Mitigating Spread Betting Risk
Arbitrage involves betting two ways at the same time. The prices of equal financial instruments can vary in different markets or between different companies. Thus, you can buy the same asset low and sell it high simultaneously. Arbitrage takes advantage of market inefficiencies to secure risk-free returns. Opportunities for arbitrage in spread betting are limited because investors have access to so much real-time information that there are few market inefficiencies to be identified.
However, it is still possible when two companies take different stances on the market while setting their own spreads. Since the top end of a spread from one company is below the bottom end of the spread of another, you can buy low and sell high. Shifts in the market do not affect profits. While people think of this as a risk-free strategy, you still need to execute the trade seamlessly to pull it off and that is after identifying the opportunity.