How Do Spread Betting Firms Make Money

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How Do Spread Betting Firms Make Money
You are here: Home > Trading FAQs > How do Spread Betting Companies make money? Do they hedge or are they betting against clients?
B ut how do providers make money? Do they hedge or are they betting against clients?
Just wondering: if you’re always paying out to winners, how do you make the money then? Say the spread is 2 pips and someone is always making 50 pips, aren’t you making a loss of 48 pips? Where does the money come from in this model to ‘pay out’ the winners? Given that from my understanding, the ‘balancing’ exercise only occurs when a spread betting position is closed? Presumably for it to work there must be a balance of people betting in the opposite direction?
It is a misconception that spread betting companies rely on losers to provide the company’s profits. Spread betting providers aren’t daft, and the bigger ones are likely to hedge their bets using the underlying assets – if most traders are placing bets on a BP recovery, the bookie will buy the underlying stock to lay off the risk.
“In some dark corners of the internet, you can find claims that IG Index bets against its own clients. That’s not really the spread betting provider is doing at all. The company doesn’t care if the client wins (or, in truth, if he loses, as long as he keeps playing/trading); it does care about being able to hedge the downside risk though.”
Of course spread betting provider do run residual positions. Most allow traders to bet in GBP while providers have to hedge in USD or JPY or whatever. Some spread betting companies even permit people to trade in 10 pence, and obviously it is not possible to hedge a 10p a point of Vodafone…
Here’s what an experienced had to say -:
Spreadbetters are Bookmakers…full stop
My father and Grandfather were bookmakers in the 60’s and 70’s
They made a “book” on every race they covered…the name of the game was to ensure they made a small % return on every race by overounding the odds (if they could) and/or by laying off larger bets into the larger money men in the business to ensure they never got stung on a big (losing) bet.
To cut a long story short the greedy ones took risks and did not lay off…taking the risks themselves covering the big bets…if it went wrong they disappeared (under concrete) or ran away…if it went right they made a lot of money…lots of money.
Spreadbet firms pretty much do the same but make even more money than this…they can lay off the big bets to the wider market and still take a nice margin on the spread offered …and also if they chose they can simply take the opposite side of a trade and just plain gamble against the trader where winner takes all… no lay offs…all profit if it works in their favour.
The kicker here is that their isn’t no horse charging over the line to decide the absolute win/lose outcome…the Spreadbetter can “control” the price of the market and thereby mitigate any potential losing bets they are taking hits on…and maximise the win…
Depending on the degree of hedging that is put in place which may vary from company to company, what they want is activity to make money off the bid/offer spread. You need to understand here that spread betting is not exactly trading (and spread betters are bookmakers not brokers) and you’re not participating in the market. It’s all in-house environments. They stream prices (which are easily manipulated) to you which follow the real market and let you bet on the outcome. The spread is their commission, that’s how they make money.
The key for providers is to have a large enough book to hedge internally without having to pay the market – there are actually other methods of reducing risk but if hedging is real, they’re definitely doing in internally.
One client goes long FTSE, another will go short. You are netted off and capturing risk free spread. Do that over 50k clients every second of a 24 hour day and it soon adds up. You still run exposure but it is ‘total’ and not specific to individual clients. Large trades, above your tolerance you simply hedge regardless and take the commission.
The perfect situation for a spread betting company is when the opposite sides (buy and sell) match – then they pick up the spreads and live happily after. So hedging would be to sum up the total value of buys and sells for an instrument (say EURUSD) and if the ratio is 60k:40k they would add the 20k to match the positions and pick up the spread. It’s kind of how market makers (or bucket shops if you will) make money in spot fx market.
If you specifically bet against the client you have to have a lot of staff who are paid to simply monitor what the clients are doing and adjust spread, fill timings etc to ensure the bulk of trading is in your favour. Either that, or you have to run enormous exposure on your book and rely on the stat that most clients lose. However, when the collective wins, as happened last year, you are crucified.
With spreadbets, spread betting brokers quote their own bid/ask prices that are -:
So when a spread betting provider gets a client that is trading in big size or is a consistent winner they hedge (or as a bookie calls it lays off the bet). This can causes some people problems because the trade is no longer instant and will cause a short term trader / scalper to lose their advantage. If the trader is a longer term trader then it is not a problem, the spread betting company can hedge the bet and make money on the commission and the trader will win or lose depending on their system. If you are a profitable scalper then you cannot use a spread betting company, you must move to a broker account and then your system has to generate sufficient profit to exceed the trading costs. You can’t have your cake and eat it, if you expect a spread betting company to continually lose money to you then how do you expect them to stay in business. Einsteins definition of insanity is doing the same thing repeatedly and expecting a different result.
In any case for the vast majority of clients, as long as a provider’s price accurately tracks the underlying and you can trade with limited slippage, there is little to worry about – particularly if the firm itself is financially healthy. We just need good prices based on the underlying market, consistent execution, with no delays and rejections caused by spread trading companies ‘reading ahead’…
Proof that spread betting providers hedge from a person posting on a bulletin board:
“Right just picked up this response from the Managing Director of Spreadex posted on the iii board and it backs up exactly my Findings that Spreadex have brought and paid for the entire 17.65% Holding in Canisp and it was never a spreadbet as they do not do CFDs for companies with a market capitalisation below 7mln!!”
“This is the reply that I received from Spreadex today. It is a 100% genuine investment and as you can see if Canisp fold, they are set to lose, if my maths is correct, over £600,000. This has cemented my views on this stock and I will be holding awaiting news.”
“Many thanks for your note. You are clearly an observant holder of the stock!! As you are aware Spreadex offers financial spread bets and CFDs to its clients. It is not part of our business model ‘to bet against our clients’ and therefore we hedge most of our risk. Such hedging is achieved by buying the underlying stock either as fully paid up stock or a CFD. In the case of Canisp – we have purchased our holding as fully paid up – hence our entry on the share register.”
“We are therefore cheering on the share price on behalf of our client.”
“I hope I have answered your question – but please do not hesitate to contact me if I can provide any further information.”
Jonathan Hufford
Managing Director
www.spreadex.com
But it is NOT Spreadex ‘buying’ the stock, he states quite clearly that they ” do NOT bet against their clients”, so a client took a position and Spreadex went and bought in the market to cover the wager. Clearly Spreadex were happy to make an exception in this case regards market cap.
Simon Denham, CEO at Capital Spreads had this to say: ‘Whilst customers are clearly quite important to spread trading firms traders should try to avoid thinking too personally about their trades. For most clients we are totally unaware of their individual deals as the trades simply go into one huge pot which we refer to as the “risk book”‘. Normally, we only concern ourselves with the net position on the “risk books” and as such clients making ten/twenty pound trade/order in any market simply won’t register. Almost all our clients are on auto-execution which can be even better than direct market access trading as it means that you will almost always be filled on trade whereas on DMA you must rely on their being sufficient liquidity to your trade request. Winners/Losers ratios on spread trades are almost exactly the same as private clients using Futures/Forex Trading/Margined Equity ‘
An interesting point is that a spread trading company will actually want you to make money or breakeven to continue trading. Why? Because losers may end up being bad for business. Nobody will recommend it to others if they have just lost a packet. If you win, even win a lot, a good spread betting company won’t mind because they don’t carry that risk themselves. They balance the buy bets with the sell bets and if there is a significant difference, they lay that risk off on the market. All they are interested in is making the spread on every trade.
However, I’ve heard that spread betting providers might not particularly like consistent small winners who bet with small stakes, i.e a spread betting provider is unable to hedge against tiny 50p/£1/£2 pp stakes. I’m not sure if this is actually so much of a problem because providers could always aggregate shorts and longs (in any given instrument) – and it doesn’t really matter to them whether this pot is made up by a handful of big betters or an army of tiny punters. I think the only thing that might bother them is if there is a huge discrepancy between longs and shorts: then they would have to protect themselves. Having said all that, at the end of the day it’s down to spread betting company to manage the risk, and it’s down to them to decide if they want to hedge or take the risk. All, I know for certain is that if you trade successfully all of the brokers will go out and hedge your positions (if they cannot balance the books internally and your stake is significant). They cannot always hedge pound for pound so they run part of business as a bookie and part as broker, mainly broker these days.
The idea is they make money on the spread but within a broader context of all positions per instrument, eg, all FTSE positions would be hedged as much as possible in underlying etc and yes like a bookie they must balance the unhedged part of business but put it this way, if you traded anything that has genuine exchange data (i.e. anything except FX) then the spread bet price would be exactly as exchange with a spread around it and much more transparent for us clients.
“Spread betting providers make their money primarily through the dealing spreads but also from currency conversions, financial charges and other factors”
Good spread betting firms make profit because they understand and manage risk. The exact opposite of most of their clients. Spread betting providers earn their money on spreads. You should also be aware that if you let your trades run overnight to the following day then you will also be charged a small financing fee which is based on LIBOR, plus any extra commission that the spread betting provider wishes to add. Assuming the spread betting provider will do its best to stay risk neutral, they will want you to trade as much as possible and thus earn the spread over and over. This is because you can milk a client who is making money for a lot more on the hidden extras like spread, funding, data fees, loss of interest on capital, currency transfers. ..etc.
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A: Spread betting providers make money in a variety of ways. Spread betting brokers make the most of their money from the spread; they typically add a small margin above the usual market spread, so a share priced at 100p to sell and 102p to buy might be 99p to sell and 103p to buy via a spread bet. For instance as I'm writing the spread around the underlying bid and offer of Vodafone is a total of 20 basis points (0.2 of 1 percent). The spread means that at any given time, the price that you can buy at is always higher than the price you can sell at. This also means that the provider makes a profit from the spread whether you win or lose.
Your spread bet does not affect the share price of vodafone as it is a contract between yourself and the spread betting provider. So, if you go long by 10 pounds a penny the provider is effectively short 10 pounds. Bear in mind that there may be thousands of trades in vodafone throughout the day so the provider's overall position may be constantly changing. Ideally, for every trader placing a long position with a spread betting provider there is another trader placing a short bet. This means that one trader will win and one will lose, and the provider will end up simply making money from the spread. In practice, depending on the nature and overall size of the provider's 'book' they may also hedge their exposure independently - which could take the form of buying or selling shares on an exchange. However, the fact is that if a spread betting firm doesn't hedge your bet in the wider market, then they stand to win when you lose and lose when you win.
Also note that for a stock like vodafone there is plenty of liquidity but for others there may be very little so a provider may potentially offer a limited size in which to trade. Many illiquid stocks (in the open market) have a number of market makers that offer prices, but again, only in a certain size (normal market size - NMS). The normal rule of thumb would be that the provider is able to offer the equivalent as a spread bet so that that they can cover that bet fully (and not over-expose themselves).
And they also charge you financing on your open spread bets (currently about 5% a year) - this either takes the form of a daily financing charge or by adjusting the price of your bet. Of course they will also make money on the interest generated on unencumbered funds...and all these charges taken together do add up so it is imperative that you shop around for the best combination of spreads, margin and financing rates.
In practice they make most of their monies in four ways -:

1. Providers assume a degree of risk on a B book.
2. They agency broke big clients or A book clients and capture commissions.
3. They capture the spread from different clients trading on opposite sides of the price simultaneously.
4. They charge overnight funding to rollover positions.

The B book for most spread betting firms will be where they make most of their money. Spread betting firms take a look at the entire B book (not individual B book clients) and some human trader takes a view as to how much of the the net risk IG wants to take (the rest of the risk is laid off in the underlying market).

IG (in this case) will decide on what is a reasonable amount of risk to run from their client flow. The spread the client pays when he initiates the deal is enough of a disadvantage to make the spread betting company a slight favourite. This advantage of risk to the market maker is why they run B books. The spread betting company will not run risk against all of its clients, only the ones that haven't been allocated 'A' book. EVERY other client is 'B' book and these are the clients that the spread betting company takes on. Too many B book clients trading in one direction will mean that the risk limits of the spread betting firms will be breached and a hedge or series of hedges in the underlying market will be executed and the risk returned to its accepted levels. This is the only time B book clients are hedged and it is done as little as possible. When the spreadbet company hedges in the market they are paying someone else’s spread and that can mount up to an expensive cost that is avoided unless absolutely necessary.

'A' Book clients. This is easy no risk business for spreadbet companies. An A book client is a client who always deals in big enough size that the B book risk limits are bust and a hedge will need to be done to reduce the B book risk, or he is a client who is good and is backed off so the risk is with the underlying market rather than the broker. Depending on your relationship with the spread betting company an A book client will be charged anywhere from a specially negotiated fee to a premium on the standard spread. Spreadbet firms do not retain any risk from A book clients.

Client X sells £10 a point EUR/USD at 1.2350 at the same time client Y buys £10 a EUR/USD at 1.2352. The spreadbet firm has no risk (the 2 clients have hedged eachother) but has locked in £20 profit from the spread. Happens more often than you'd imagine.

Overnight funding is a revenue stream. I don't think any Spreadbet firm has ever denied this. Simply the underlying market will apply market funding to the total net position of the spread betting provider, whilst the spread betting company will widen the funding and apply it to EVERY client position rather than the net position.
Perhaps the right question to ask is: How do spread betting providers NOT make money?

The December 2009 trading update from London Capital Group provided some interesting insights into their business model. The shares of LCG took a battering after the group posted a profit warning. This is interesting in that London Capital Group are becoming a sizable player in the spread betting industry operating both their own brand (LCG) as well as a number of major white-label partners including: Intertrader and SaxoSpreads.

Reading from the trading update, a number of interesting factors contributed to the profit warning that I think spreadbetters would find interesting:

1) Development of these white label partner sites is turning out to be costly.

2) Spread betters are winning more. Which of course is good news for us. This seems to imply that when the market is stable (i.e. relatively predictable), and with the markets in a general upward direction since March 2009 (to December 2009) it becomes easier for punters to come out on top. 'Less volatility means that people are more confident about sitting on their positions when the market goes the other way,' on analyst from the Financial Times was quoted as saying. Thus less people close out their losing positions, which is how spread betting providers make large portions of their monies.

For spread betting providers, the worst conditions appear to be slow-moving markets - as they encourage spread traders to hold a single spreadbet as opposed to jumping in and out with fresh bets. Low trading volume and having to split revenues with white-label partners can dent profits during calm markets. But volume and profits soar when volatility is high - as is the case at present...
A: Technically, yes this is correct - when you take on a spread bet, you're taking a bet against the spread betting company as it acts as the counterparty
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