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Spreading the risk

Created:
2 July 2008
Updated:
19 November 2008
Written by:
Dominic Picarda

As someone who watches financial markets closely, you probably stumble across quite a few juicy short-term opportunities. Maybe you think banks are due a nice little rally soon, or that crude oil is looking a bit toppy at the moment. However, if you've only got a regular stockbroking account, the chances are that you have no way to exploit your insights. If this rings true, it's time you considered spread betting.

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With a spread bet, you can nip in and out of a huge range of assets instantly. It's the perfect way to exploit your gut instincts about the next few hours' or days' action in the markets. What's more, you don't need deep pockets to do it, the costs involved are low, and you don't have to share any of your profits with those lovely folks at HM Revenue & Customs.

The basics

If you've ever dealt in physical shares, the spread-betting process will be very familiar to you, with prices quoted in exactly the same way. So, if you're interested in trading Barclays' shares, you simply call up the spread-betting firm or look at its website. The spread-betting firm will quote you two prices, a lower one at which you can 'sell' the shares and a higher one at which you can 'buy' the shares.

Of course, with spread betting, you're not actually buying and selling the asset in question. All you're doing is having a punt on whether it goes up or down. So, if you 'buy' a Barclays spread bet and the shares subsequently rise, you receive the difference between the price when you opened the bet and the price when the bet closes.

But why not simply buy Barclays' shares to profit from your belief that they're going up? The answer is expense, especially if you're only expecting a gain of, say, 5 per cent over a week. Were you to buy Barclays' actual shares, you'd have to pay stockbrokers' commission, stamp duty and any profits would potentially be liable for capital gains tax.

Let's look at this example in more detail. The spread-betting firm quotes you a price of 400p-401p for Barclays' shares. You think they're heading higher, so you 'buy' this spread at 401p, staking £10 per point. The value of your total position is therefore 401p x £10 or £4,010. Your insight proves correct and Barclays shoots up 9 per cent over the following week.

Once again, you go to the spread-betting firm's website and see that they're now quoting Barclays at 436p-437.1p. You decide to sell up for 436p (as with shares or currencies, you always buy at the higher price and sell at the lower price). So, you receive 436p x £10 = £4,360. Your profit on this transaction is therefore £4,360-£4,010 = £350. Not a penny of this goes to the taxman, because it is classed as a bet rather than an investment. And, although tax laws can change, it's unlikely that the government would tax spread-betting profits, as this would open the door to spread bettors offsetting their losses against taxes.

Had you done the same deal using actual shares, you’d have paid stamp duty at 0.5 per cent, stockbrokers’ commission, and stood to pay capital gains tax on the profit. And that’s only the beginning.

The flexible way to trade

Spread betting also allows you to make money when share prices go down. This practice – known as short selling – is not really a possibility for private investors in the UK.

Fortunately, it's as easy as pie if you're using spread bets. Taking a short position involves nothing more than pressing a different button when placing your order. So, you simply begin by selling rather than buying, and close your position by buying rather than selling. The ability to 'go short' is hugely valuable in volatile markets such as those we've experienced over the past year or so.

To see this in action, let's say you reckon that the FTSE 100 is ripe for a bout of selling. A spread-betting firm quotes you a price of 6000-6001. You place a sell order at 6000 at £1 a point and sit back. Sure enough, the UK large-cap index suffers a fall of 250 points over the next few days. Now the spread betting firm is quoting a price of 5749-5750. Your profit is the 250-point fall multiplied by your stake of £1 = £250.

Of course, you could always use much larger sums. You might open a position on the FTSE for £10 a point or perhaps even £100 a point, if you could really afford it. The point here is that you don't need a fortune to get started in spread betting. Some firms will let you open positions staking as little as 50p a point. Thus your total position may only amount to a few hundred pounds, which hardly represents a demanding commitment.

So far, we've only considered spread bets on UK shares or share indices. But it's just as simple to place spread bets on foreign shares, bonds, interest rates, commodities or foreign exchange. With one firm, you can even bet on UK house prices. And you can do all this from one single spread-betting account. Were you to take actual positions in, say, a US equity, a foreign exchange pair and an interest-rate future, you might easily require three different accounts.

What's more, there's no exchange rate risk or currency commissions with spread betting. All your trades will be denominated in pounds sterling. This is obviously an advantage where you're trading something like New York-listed Google. If you're dealing in the actual shares, you could end up losing money even if the share price moves as you expected, simply because the US dollar goes down versus the pound.

Probably the most exciting aspect of spread betting is that it allows you to make big returns off small movements in the market. This is known as 'leverage', which simply means you can take big positions without having to come up with a big stake. In the case of buying real shares, a stockbroker will require you to have all the necessary funds in your account to finance your purchase. So, to buy £10,000-worth of Barclays' shares, you'd have to deposit the same amount in your account.

By comparison, it is possible to establish a £10,000 spread-betting position in Barclays by putting up just £1,000. This deposit is known in the industry as your 'margin'. The advantages of only having to come up with a fraction of the total position you wish to control are obvious. For starters, you can keep your money working elsewhere.

By only committing a fraction of the total value of your trade, you magnify the potential rewards. So, say you have a £10,000 long position in Barclays, with margin of 10 per cent. Barclays then goes up 10 per cent. You have made a profit of roughly £1,000 – the same as you would have had you held the actual shares. But since you only put up £1,000, your return is 100 per cent, rather than just 10 per cent.

This sounds impressive and indeed it is. But it cuts both ways: a 10 per cent fall in Barclays' share price would wipe out your 10 per cent stake entirely. In order to keep this trade open, the spread betting firm would demand you put up further margin. The problems arise when punters overextend themselves.

Say you've £10,000 in your account and you take a position in one company's shares worth £100,000. Let's now assume that the company gets into extreme difficulties and its share price falls 25 per cent in one go. Suddenly, you've lost your original £10,000 and you owe your spread betting firm £15,000. You will need to produce that cash from somewhere. If you are wealthy and have plenty of liquid assets, there'd be nothing to worry about. But if not, things would clearly get very hairy.

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Controlling your risks

The message here is simple: while spread betting is a powerful tool, it can be financially lethal in the wrong hands. However, there are some obvious steps that you can take to make sure you don't end up in difficulties. The first thing is only to enter positions that you can afford to take. This sounds blindingly obvious, but many novice spread bettors totally disregard it.

The amount of money you should risk when spread betting is therefore only the sum that you can genuinely afford to lose. Think of spread betting as being the "high risk" portion of your total assets, a small but exciting corner of your overall portfolio.

On a day-to-day basis, you also need to apply strict discipline to your spread betting. This involves working out how much to commit to each trade, and the levels at which you'll take profits or cut your losses. Money management is every bit as important as the business of deciding which trades to enter.

You can read in greater detail about the art of money management in Rakesh Shah's article 'Watching the pennies'. For now, though, it's worth mentioning the vital piece of safety equipment that every spread bettor needs to use: the stop-loss. A stop-loss order is your means of escape if things go wrong. At the time you open your position, you state a level at which you wish the trade to end automatically if things go against you.

Perhaps you're betting that the pound will rise against the euro, and enter a trade at E1.2423. However, you also need to determine at what level you'd admit you were wrong and get out. So, you might say that if the pound falls instead of rising, you would automatically get out of your position when the price touches E1.2380. With a stop order, the spread-betting company would instantly end your bet at this level, so there'd be no need to worry about unlimited losses.

Some spread-betting firms will actually insist that you place a stop order and will place one for you anyway if you don't specify one. Some also offer a special sort of stop order that comes with added security: the guaranteed stop. With an ordinary stop-loss, there’s always a risk that the price will shoot straight past your specified stop-loss level, leaving you facing bigger losses than you'd allowed for. A guaranteed stop-loss means you will always get out at the specified price, even if the market surges through your level.

It is also possible to use spread betting to manage risks as well as to take them. For example, you can hedge your exposure elsewhere using spread bets. Maybe you've got a lot of Vodafone shares and you're worried that they're heading for a fall in the near term, but you don't want to sell them as you think they'll recover and disposing of them would also trigger a capital gains tax bill. So, you can sell a Vodafone spread bet for the amount of your liability, thus netting off most of the risks.

Admittedly, spread bets aren't an exact match for the underlying asset in these situations. Whereas shares and other such assets are liable for tax, spread bets aren't. While this is clearly a good thing when your spread bet wins, it is bad when you lose as you can’t offset the loss against capital gains elsewhere.

How to pick spread bets

Choosing spread betting positions is very different to selecting shares or other assets for your main portfolio. The things that make an asset a desirable holding for the long term are often distinct from what is going to make them rise over the next few hours or days. So, you might believe that gold has excellent prospects over the coming years, owing to the return of inflationary problems in the US. However, this insight may have little bearing on gold's movements over the next two weeks.

You can use company insights when spread betting shares. You might be an avid follower of Tesco, say. Recently, the market may have become seemingly gloomy on the supermarket chain's prospects, unjustifiably so in your opinion. Your instincts and research tell you that they are likely to report better-than-expected earnings when they report next week and so you take out a spread bet. Sure enough, Tesco then publishes impressive sales figures and the shares bounce, leaving you with a tidy profit.

The most common method of identifying trading opportunities is technical analysis. Looking at price charts tells you a great deal about an asset's current behaviour. The main principle here is that the 'trend is your friend' and that we should try to identify stocks that are moving strongly in one direction and try to ride it. Of course, there's a bit more to it than simply spotting things that are going up or down.

You can learn more about charting techniques and trading strategies that make use of them in my article 'The Gann plan for spread-betting success' and in Rakesh Shah's pieces on 'Winning strategies for spread betting'.

MORE ON SPREAD BETTING:

Investment guide to spread betting

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