You are here:

How spread betting prices are generated

Created:
25 November 2005
Written by:
Dan Oakey

The prices that a spread better uses come from the stock market. They take the price as quoted in the market, add a spread to it, and then package it as a financial 'bet' to whoever wants to accept it.

Advertising

You do not have to use spread bets for very long, though, to discover that the short answer given above is just not good enough. Sometimes you will see a price in the market that is not reflected by a spread better. Sometimes the prices quoted by a spread better will be higher or lower than those in the market. And the spread betters' and market prices don't always move in tandem.

These differences between market prices and the quotes from a spread better naturally arouse suspicions - especially when an investor has just lost money. They suggest that the spread-betting firms really are glorified bookmakers, shortening or lengthening the odds just to make sure that, no matter what happens, they still make a profit.

And what is particularly damaging about this view is that we all know the fate of the average racing punter - they lose money. The greater their losses, the bigger the profit for the bookie - it's a zero-sum game with the odds loaded in the bookies' favour.

In order to be confident in your spread bets, then, you must have confidence in the prices on which you trade - where they come from, and why they can occasionally differ from what you would see on a price feed from the London Stock Exchange (LSE).

The common assumption among many traders is that spread betters can quote whatever price they want. Once you have opened a position, you have to accept whatever price the spread better decides in order to close it.

Ultimately, that is true. Look at the fine print of a spread-betting contract and you will normally see a clause to that effect. A spread better reserves the right to change its spreads as it sees fit. Give someone the power to change the spreads, and you allow them to dictate the prices.

That said, competition acts to keep them honest. At the last count, there were a dozen spread-betting companies licensed by the Financial Services Authority (FSA). As a customer, you can choose between CMC, IG Index, City Index, Cantor, TradIndex, Finspreads/IFX Markets, Man Spreads, E*Trade, iDealing.com, Spreadex, Blue Square and Global Trader. Most experienced traders have set up accounts with several spread betters and routinely compare spreads and service levels.

In fact, the talk within spread-betting circles is that there are too many firms chasing too few customers. So expect a round of takeovers in the next year or so - especially if CMC Markets floats as planned, and IG or City Index also join the stock market.

Better still, this competition is not just between spread-betting firms. If you don't like the prices quoted by a spread better, but you still want to go long or short of stocks using financial leverage, you can use a contract for difference (CFD), a futures contract, a binary bet, an option or a covered warrant.

Consider all the firms offering CFDs and other derivatives, and you should see that a spread better who consistently posts wonky prices is not going to last long.

Also remember that most of a spread better's profits come from regular traders. The company's trading platform will offer the same prices to a novice as to an old hand trading dozens of times a day. In effect, the beginner can trade on prices sharpened by the cut-throat competitive practices necessary to attract and keep professional customers. And if you are still not happy, you can always vote with your feet.

Not convinced?

Good for you!

It is always a good idea to understand for yourself why price discrepancies arise. To do that, though, you need to go back in time to the dawn of the spread-betting industry.

IG Index was the first spread-betting company, founded in 1974. It began as a specialist boutique, focused on giving easy exposure to gold (the initials IG stand for 'Investment Gold'), forex, and the FTSE All-Share index.

The industry grew steadily in the 1980s and early 1990s, but the typical clients were still professional traders in the Square Mile. By the late 1990s, though, retail investors had become sophisticated enough to attract the attention of the spread-betting firms.

Built on futures

Back then, all the contracts were based on futures contracts. These are not complicated. A buyer and a seller undertake to exchange shares at a given price on a given date. For example, you may agree to buy 1,000 Barclays shares from me in one month's time.

But what price should we settle on? There is no question of trying to predict what Barclays' share price will do. A futures price takes the current price and assumes it will stay the same until the contract expires. The only adjustment is for the cost of money.

To see why, remember that I am obliged to hand you 1,000 Barclays shares in a month's time. Being a prudent sort, I will want to insure myself against the risk that Barclays soars in the meantime. If that happened, I would have to accept a price for my shares that was way below the market price.

That is why I hedge myself by buying 1,000 shares in Barclays, effectively tying up some of my cash. That cash could be elsewhere, in an interest-bearing account, for example. So, to compensate myself for this, I will only sell the futures contract if the price factors in the interest that I have foregone.

So, if you buy a futures contract when it has three months left to run, it will include three months' interest. If you buy it with 17 days to run, it will include 17 days' interest. Therefore, even if Barclays' share price remained utterly static for three months, the futures price would get slightly cheaper each day as the amount of interest lessens. Apart from that, the futures price and the share price will move up and down in tandem.

One of the first mistakes that novice spread betters make is to blur the difference between a futures contract and the cash market (that is, the actual share price as published by the LSE). Barclays may be trading at 600p when you check on Ceefax, but don't expect the futures contract to do the same, unless it is expiring that day.

Until a few years ago, spread betters only offered bets based on futures prices. Then CMC Markets (called Deal4free at the time) introduced daily rolling cash bets. Essentially, all it did was to repackage a futures contract into something simpler: a bet priced at the same level as the cash market. You could now watch the price of a share on the LSE and the price (plus) spread of the spread bet and, in theory, they would be the same.

At the time, rival spread betters were aghast, fearing it would kill their profitability. Now, almost every spread better offers a daily format.

However, there are now three prices to consider: the cash price, the futures price  and the price that spread betters derive from the futures price, which is supposed to mirror the cash price.

SPONSORED LINK
For more detailed examples about how spread betting works and investment other investment information from Barclays Stockbrokers please click here

FTSE 100 foibles

The relationship between these prices should be straightforward, but there are quirks. Take the FTSE 100 index. Billions of pounds worth of Footsie futures contracts change hands every day. It has become an investment asset in its own right, and will react at lightening speed to news events and economic data.

Now compare the futures contract with the FTSE 100 index itself. The shares that comprise the index can change in value thousands of times a minute, but the index itself only updates every 15 seconds. That lag sometimes creates a price anomaly between the future and the cash price. The futures price will be more accurate and more timely because that is the price that people trade off. It matters to them that the futures price reflects all known information as soon as possible. So the future leads the index.

For this reason, investors who make a speciality of trading the FTSE 100 index using charts and technical analysis need to take special care. If you are plotting trades with reference to resistance and support levels, it is no use waiting for the futures price to reach a level that applies to the FTSE 100 index. That time may never come - or, if it does, only after the buy or sell signal has come and gone.

Even with standard spread bets on individual shares, there is more to a price than meets the eye. You might think the price quoted by a spread better for, say, Tesco should be the last price traded. That is a concrete indication of where the market last reached consensus.

In reality, though, the last traded price can become out of date very quickly. And, for smaller stocks, it is not unknown for unscrupulous traders to try to engineer a freak spike in the share price, buying only a handful of shares. That would move the last traded price well above the 'real' market price. So, if spread-betting companies allowed you to trade off the last price, they could be picked off when the price (predictably) came down from its spike.

For that reason, they use the bid and offer prices in the market, which may soon move away from the last traded price. An out-of-date price is also irrelevant for the spread better because he will only want to quote you a price that would enable him to hedge in the market.

Requotes

Even when you see a spread betters' quote and then try to deal off a price, you may be requoted a worse price when you click on the 'deal' button. This happens especially in smaller, less liquid stocks. To see why, look at the LSE order book for Soco International, below.

As you can see, the market bid-offer spread (in the middle of the yellow strip) is 480.25-485. A spread better might widen this to 475p-490p. Now imagine you want to open a long position on Soco at £30 per point, equivalent to buying 3,000 Soco shares.

Unfortunately, there are only 2,500 shares offered at the lowest price of 485p. To hedge your order, the spread better would need to buy a further 500 shares and the next available tranche of shares is offered at 490p (or 495p once the spread is added). Therefore, if you want your order filled, you will have to accept a requote at a worse price.

How they hedge

In the example above, it doesn't matter that the spread better is not actually buying shares in the market. It will still charge you as if it were, because it needs to control the total market risk.

Different spread betters handle their risk in different ways. It costs money to hedge risk in the market, and the more cheaply you're able to do it, the greater the money you have left for profit or for narrowing the spreads you offer. Partly for this reason, spread betters are reluctant to explain exactly how they hedge - it is commercially-sensitive information.

Most companies will hedge their net position, though. "If clients take opposing positions, why hedge them ourselves?" asks David Buik of Cantor Index.

A spread better that is long £2m GlaxoSmithKline (GSK) and short £1m AstraZeneca may use the fact that these two stocks are highly correlated to whittle down its net position to £1m long of GSK. If its net FTSE 100 position is short £1m, it can condense the risk still further.

As David Morrison, of Man Spread Trading, says: "There is no reason why the company should have to hedge - after all, there are many different business models and ways of assessing risk."

That said, the fancier a firm's hedging is, the greater the risk that it will come unstuck. The temptation will then be to claw back some of the losses (sometimes paper, sometimes all too real) by skewing prices.

"It comes down to what the customer feels comfortable with," argues Mr Morrison. "Would you rather feel your spread-betting company is with you or against you? You should ask outright - will you be hedging my business or not? What is your company policy on risk? If you run residual positions, how much risk do you take? These are all perfectly valid questions to put to a company if you are thinking of doing business with them."

Update rates

Another factor to bear in mind is how often the prices are updated. If you are a day-trader, every half-point move could be the difference between winning or losing on a trade. You want the maximum possible chance to get out at a profit. But if the spread better's prices only budge once the underlying market has gone up a couple of ticks, you have fewer chances to win.

All spread betters tell you their prices move in line with the market, but the exact rate of updating will vary. Global Trader, a new arrival on the spread-betting scene, makes great play of the fact that its prices change in real time with the market. It adds a fixed spread to each bet and updates the price it quotes as often as the market moves. For example, on a sterling/US dollar bet, the market may quote 17194-17196. Global's spreads will always be two ticks either side, in this instance 17192-17198. If the market moves up and the spread narrows, say to 17196-17197, then the price available to trade on would immediately move to 17194-17199.

"Those of our clients with access to Reuters are able to see the market bid and our bid moving together - allowing for the platform connection speed, which averages 0.2 seconds," says Global's Tom Hall.

  • Back to top

Win £1,000 or a golf weekend

Enter IC's Fantasy Portfolio competition for the chance of winning £1,000 or a luxury golf weekend, courtesy of ETX Capital and Celtic Manor.

Enter here for your chance to win

Advertorial Feature

Take control of your investing with CFDs

Have you ever watched a move in the markets that you saw coming, but you weren't able to exploit?

by Dominic Picarda

Advertorial Feature

Spread your risks with spread trading

With so many big moves in the world's financial markets, there have seldom been more opportunities around for spread traders. Isn't it time you joined them?

by Dominic Picarda