Spread betting is a derivative strategy, in which participants do not own the underlying asset they are betting on, such as a stock or an asset. rather, spread bettors simply speculate whether the asset’s price will increase or decrease, using the prices offered by a broker.
As in the stock market, two prices are quoted for spread bets: a price you can buy at (bid price) and a price you can sell at (ask price). the difference between the buy and sell price is known as the spread. the spread bookmaker benefits from this spread, and this allows spread bets to be placed commission-free, unlike most securities trading.
Investors align themselves with the offer price if they believe the market will rise and accept the question if they believe it will fall. The key features of spread betting include the use of leverage, the ability to go long and short, the wide variety of markets available, and tax benefits.
Origins of spread betting
If spread betting sounds like something you could do at a sports bar, you’re not far off. charles k. Mcneil, a mathematics professor who became a securities analyst, and later a bookmaker, in Chicago during the 1940s, has been widely credited with inventing the concept of spread betting. but its origins as an activity for professional traders in the financial industry occurred approximately 30 years later, on the other side of the Atlantic. Stuart Wheeler, an investment banker from the City of London, founded a company called IG Index in 1974, which offered bets on gold.At the time, the gold market was prohibitively difficult for many to participate in, and spread betting provided an easier way to speculate on it.
Despite its American roots, spread gambling is illegal in the United States.
A stock trade versus a spread bet
Let’s use a practical example to illustrate the pros and cons of this derivatives market and the mechanics of placing a bet. First, we will take an example in the stock market, and then we will see an equivalent spread bet.
For our stock market, let’s assume a purchase of 1,000 shares of vodafone (lse: vod) at £ 193.00. the price rises to £ 195.00 and the position is closed, capturing a gross profit of £ 2,000 and having made £ 2 per share on 1,000 shares. Keep several important points in mind here. Without the use of margin, this transaction would have required a large capital outlay of £ 193k. Additionally, fees would normally be charged for entering and exiting the stock market. finally, the profit may be subject to capital gains tax and stamp duty.
Now, let’s look at a comparable spread bet. By placing a spread bet on vodafone, we will assume that with the bid and offer spread you can buy the bet at £ 193.00. When making this spread bet, the next step is to decide how much to commit per “point”, the variable that reflects the movement of the price. The value of a point can vary. In this case, we will assume that one point equates to a one penny up or down change in the price of the phone’s stock. we will now assume that a purchase or ‘up bet’ is made on a phone worth £ 10 per point. Vodaphone’s share price increases from £ 193.00 to £ 195.00, as in the stock market example.in this case, the bet captured 200 points, which means a profit of 200 x £ 10, or £ 2,000.
While the gross profit of £ 2,000 is the same in the two examples, the spread bet differs in that there are usually no commissions incurred to open or close the bet and there is no stamp duty or capital gains tax due. In the UK and some other European countries, the profit from spread betting is tax free.
However, while spread bettors do not pay commissions, they may suffer from the bid and offer spread, which can be substantially wider than the spread in other markets. Note also that the bettor has to overcome the spread just to break even in a trade. In general, the more popular the negotiated security, the tighter the spread, lowering the cost of entry.
In addition to the absence of fees and taxes, the other important benefit of spread betting is that the required capital outlay is dramatically lower. On the stock market, a deposit of up to £ 193,000 may have been required to enter the trade. In spread betting, the required deposit amount varies, but for the purpose of this example we will assume a required deposit of 5%. this would have meant that a much smaller deposit of £ 9,650 was required to take on the same amount of market exposure as on the stock market.
Using leverage works both ways, of course, and herein lies the danger of spread betting. As the market moves in your favor, you will get bigger profits; On the other hand, as the market progresses, you will incur greater losses. While you can quickly win a large amount of money on a relatively small deposit, you can lose it just as quickly.
If the price of the vodaphone fell in the example above, the bettor may be asked to increase the deposit or even to have the position closed automatically. In such a situation, stock market traders have the advantage of being able to expect a downward movement in the market, if they still believe that the price is eventually going up.
Manage risk in spread betting
Despite the risk involved in using high leverage, spread betting offers effective tools to limit losses.
- Standard stop-loss orders: Stop-loss ordersreduce risk by automatically closing a losing trade once a market exceeds a set price level. In the case of a standard stop loss, the order will close your trade at the best available price once the established stop value has been reached. Your trade may close at a worse level than the trigger, especially when the market is in a state of high volatility.
- Guaranteed stop-loss orders – This form of stop-loss order guarantees to close your trade at the exact value you have set, regardless of underlying market conditions. however, this form of downward insurance is not free. Guaranteed stop-loss orders generally incur an additional fee from your broker.
Risk can also be mitigated by using arbitrage, betting in two ways simultaneously.
Betting arbitrage spread
Arbitrage opportunities arise when the prices of identical financial instruments vary in different markets or between different companies. As a result, the financial instrument can buy low and sell high simultaneously. An arbitrage transaction takes advantage of these market inefficiencies to obtain risk-free returns.
Due to widespread access to information and increased communication, arbitrage opportunities in betting and other financial instruments have been limited. However, spread betting arbitrage can still occur when two companies take separate positions in the market while setting their own spreads.
At the expense of the market maker, an arbitrage bets on the spreads of two different companies. When the high end of a spread offered by one company is below the low end of another’s spread, the arbitrator benefits from the gap between the two. Simply put, the merchant buys low in one company and sells high in another. Whether the market rises or falls does not dictate the amount of return.
There are many different types of arbitrage, allowing the exploitation of differences in interest rates, currencies, bonds and stocks, among other values. While arbitrage is generally associated with risk-free earnings, there are indeed risks associated with the practice, including execution, counterparty, and liquidity risks. Failure to complete transactions smoothly can lead to significant losses for the arbitrator. likewise, counterparty and liquidity risks can come from the markets or the failure of a company to carry out a transaction.
The bottom line
Continuously developing in sophistication with the advent of electronic markets, spread betting has successfully lowered entry barriers and created a vast and varied alternative market.
Arbitrage, in particular, allows investors to exploit the price difference between two markets, specifically when two companies offer different spreads on identical assets.
The temptation and dangers of being over-leveraged continue to be a major stumbling block in spread betting. However, the low capital outlay required, the risk management tools available, and the tax benefits make spread betting a compelling opportunity for speculators.
