Is Spread Betting Leverage

Is Spread Betting Leverage

Dan Blystone is the founder and editor of TradersLog.com, as well as the founder of the Chicago Traders Meetup Group.

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Spread betting allows traders to bet on the direction of a financial market without actually owning the underlying security. Spread betting is sometimes promoted as a tax-free, commission-free activity that allows investors to speculate in both bull and bear markets, but this remains banned in the U.S. Like stock trades, spread bet risks can be mitigated using stop loss and take profit orders.

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Spread betting is a derivative strategy, in which participants do not own the underlying asset they bet on, such as a stock or commodity. Rather, spread bettors simply speculate on whether the asset's price will rise or fall, using the prices offered to them by a broker.

As in stock market trading, two prices are quoted for spread bets—a price at which you can buy (bid price) and a price at which you can sell (ask price). The difference between the buy and sell price is referred to as the spread. The spread-betting broker profits from this spread, and this allows spread bets to be made without commissions, unlike most securities trades.

Investors align with the bid price if they believe the market will rise and go with the ask if they believe it will fall. Key characteristics of spread betting include the use of leverage, the ability to go both long and short, the wide variety of markets available, and tax benefits.

If spread betting sounds like something you might do in a sports bar, you're not far off. Charles K. McNeil, a mathematics teacher who became a securities analyst—and later a bookmaker—in Chicago during the 1940s has been widely credited with inventing the spread-betting concept. But its origins as an activity for professional financial-industry traders happened roughly 30 years later, on the other side of the Atlantic. A City of London investment banker, Stuart Wheeler, founded a firm named IG Index in 1974, offering spread betting on gold. At the time, the gold market was prohibitively difficult to participate in for many, and spread betting provided an easier way to speculate on it.

Despite its American roots, spread betting is illegal in the United States.

Let's use a practical example to illustrate the pros and cons of this derivative market and the mechanics of placing a bet. First, we'll take an example in the stock market, and then we'll look at an equivalent spread bet.

For our stock market trade, let's assume a purchase of 1,000 shares of Vodafone (LSE: VOD ) at £193.00. The price goes up 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. Note here several important points. Without the use of margin, this transaction would have required a large capital outlay of £193k. Also, normally commissions would be charged to enter and exit the stock market trade. Finally, the profit may be subject to capital gains tax and stamp duty.

Now, let's look at a comparable spread bet. Making a spread bet on Vodafone, we'll assume with the bid-offer spread you can buy the bet at £193.00. In making this spread bet, the next step is to decide what amount to commit per "point," the variable that reflects the price move. The value of a point can vary.

In this case, we will assume that one point equals a one pence change, up or down, in the Vodaphone share price. We'll now assume a buy or "up bet" is taken on Vodaphone at a value of £10 per point. The share price of Vodaphone rises from £193.00 to £195.00, as in the stock market example. In this case, the bet captured 200 points, meaning 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 no stamp duty or capital gains tax due. In the U.K. and some other European countries, the profit from spread betting is free from tax.

However, while spread bettors do not pay commissions, they may suffer from the bid-offer spread, which may be substantially wider than the spread in other markets. Keep in mind also that the bettor has to overcome the spread just to break even on a trade. Generally, the more popular the security traded, the tighter the spread, lowering the entry cost .

In addition to the absence of commissions and taxes, the other major benefit of spread betting is that the required capital outlay is dramatically lower. In the stock market trade, a deposit of as much as £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 5% deposit. This would have meant that a much smaller £9,650 deposit was required to take on the same amount of market exposure as in the stock market trade.

The use of leverage works both ways, of course, and herein lies the danger of spread betting. As the market moves in your favor, higher returns will be realized; on the other hand, as the market moves against you, you will incur greater losses. While you can quickly make a large amount of money on a relatively small deposit, you can lose it just as fast.

If the price of Vodaphone fell in the above example, the bettor may eventually have been asked to increase the deposit or even have had the position closed out automatically. In such a situation, stock market traders have the advantage of being able to wait out a down move in the market, if they still believe the price is eventually heading higher.

Despite the risk that comes with the use of high leverage, spread betting offers effective tools to limit losses .

Risk can also be mitigated by the use of arbitrage, betting two ways simultaneously.

Arbitrage opportunities arise when the prices of identical financial instruments vary in different markets or among different companies. As a result, the financial instrument can be bought low and sold high simultaneously. An arbitrage transaction takes advantage of these market inefficiencies to gain risk-free returns.

Due to widespread access to information and increased communication, opportunities for arbitrage in spread betting and other financial instruments have been limited. However, spread betting arbitrage can still occur when two companies take separate stances on the market while setting their own spreads.

At the expense of the market maker, an arbitrageur bets on spreads from two different companies. When the top end of a spread offered by one company is below the bottom end of another’s spread, the arbitrageur profits from the gap between the two. Simply put, the trader buys low from one company and sells high in another. Whether the market increases or decreases does not dictate the amount of return.

Many different types of arbitrage exist, allowing for the exploitation of differences in interest rates, currencies, bonds, and stocks, among other securities. While arbitrage is typically associated with risk-less profit, there are in fact risks associated with the practice, including execution , counterparty, and liquidity risks. Failure to complete transactions smoothly can lead to significant losses for the arbitrageur. Likewise, counterparty and liquidity risks can come from the markets or a company’s failure to fulfill a transaction.

Continually developing in sophistication with the advent of electronic markets, spread betting has successfully lowered the barriers to entry and created a vast and varied alternative marketplace.

Arbitrage, in particular, lets investors exploit the difference in prices between two markets, specifically when two companies offer different spreads on identical assets.

The temptation and perils of being overleveraged continue to be a major pitfall in spread betting. However, the low capital outlay necessary, risk management tools available, and tax benefits make spread betting a compelling opportunity for speculators.

You are here: Home > Learn Spread Betting: Training Course > Leverage – A Spread Betting Context
In my view, the misunderstanding of leverage is the number one reason why people lose money at spread betting. I have read countless horror stories on bulletin boards of how people bet too much and lost everything. Spread betting, by its very nature is a leveraged product . This means that you can lose more money than is actually in your trading account.
If a trader has £5,000 in their trading account, they bet too much and they end up losing £9000, that’s another £4,000 they have to find to cover their losses by paying back their spread betting provider. We will return this idea later with a practical example. For now, it is important that we focus on the things that will help us avoid being another horror story on a bulletin board.
In regard to spread betting, leverage (or margin ) refers to the ability to purchase a larger amount than would otherwise be possible by using borrowed money from your spread betting provider at an extremely low interest rate .
Let us break this description down into its constituent parts:
To understand these ideas, we shall look at the portfolios of two different traders: Mark and Sally . Mark makes purchases of shares in the normal way and Sally uses leverage via a spread betting account. Both make identical trades but have different outcomes in regards to losses.
1. The ability to purchase a larger amount than would otherwise be possible
Mark’s share portfolio, starting capital: £10,000
Discounting commissions and stamp duty, Mark has used almost all of his money; he has used nearly all of his £10,000 on share purchases and only has £50.00 left in his account. Mark has not used any leverage.
Sally’s spread betting portfolio, starting capital £10,000
Sally has made identical purchases to Mark: £9,950 worth of exposure of shares. Sally only needs to pay her spread betting provider £1990 or 20% of the value of the shares she has purchased . This is what is meant by being able to purchase a larger amount than would otherwise be possible. It leaves Sally free to open more spread bets if she spots an opportunity in the markets. Mark cannot make further trades as he has used almost all of his money.
This is one of the great advantages of spread betting compared to normal share dealing; leverage allows small account holders access to the financial markets.
2. Using borrowed money from your spread betting provider
In Sally’s example above, she is borrowing £7,960 from her spread betting provider (£9,950 – £1,990 = £7,960) to gain exposure to £9,950 worth of shares. This happens with every type of spread bet: shares, commodities, currencies or any market your spread betting provider quotes a price for. The amount you borrow depends on each spread betting provider’s margin rates .
“The amount you borrow depends on each financial spread betting provider’s margin rates.”
In our example, we used a margin rate of 20% but you will need to check with your provider what rates they will quote you.
Margin rates will also depend on the type of company being quoted. Mark and Sally’s portfolios contain FTSE 100 companies at the time of writing.
You can expect margin rates to be low on these types of large companies. If they are smaller companies such as on the AIM market, you should expect margin rates to be higher .
In exchange for borrowing from her spread betting provider, Sally will be charged a small finance fee . Each spread betting provider charges different rates but they are usually so small they are barely worth thinking about.
For example, a well known spread betting firm charges daily interest on a FTSE 100 stock at LIBOR 0.5% plus a ‘loading adjustment’ of 2.5% per annum. This works out at 0.5% + 2.5% divided by 365 = 0.008% per day. These small amounts vary, but do check the terms and conditions before signing as a new client.
“The finance cost for spread betting is so low, that it is still a cheaper alternative to traditional share dealing.”
Generally speaking, the finance cost/interest rate for spread betting is so low, that it is still a cheaper alternative to traditional share dealing as we have seen.

The advantages of leverage are obvious: getting more (exposure) for your money and freeing up your cash for further trades are two that immediately spring to mind. But what are the disadvantages?
The main disadvantage to leverage is that some (losing) traders do not understand how leverage works; just because you only pay the spread betting firm a fraction of the real cost of trading, does not mean that fraction is all you can lose on each trade. Be aware that you can lose more. Much more.
Let’s compare Mark and Sally’s portfolios again to explore this further. Below are purchases made by our traders. Notice how Mark has paid the full amount for his shares at £4,000 and that Sally has only paid £800 margin to get the same value of exposure as Mark.
If the price of Vodafone goes down by half to £5.00 a share and they both sell at the new lower price, then Mark and Sally will each lose £2,000. Let us see how this will effect their portfolios:
Mark purchased 400 shares costing £4,000 and now sells them for £2,000, losing £2,000 . Sally purchased a spread bet costing £800 (margin) for £4,000 worth of shares and sells her spread bet for half the original price, she also loses £2,000 .
Notice how Sally loses the same amount of money as Mark even though she did not spend the same amount of money as Mark on her Vodafone trade; as we have seen, leverage allows you to purchase a larger amount than would otherwise be possible.
Sally’s purchase price (margin) of £800 was overtaken by her loss of £2000. Mark actually gets back £2000 into his account but sally loses her margin (£800) and an extra £1,200, a total of a £2,000 loss.
What if Sally had used all the cash in her account on margin? And what if her entire portfolio fell in value by 50%? She will lose more money than is actually in her account making her a debtor!
Some spread betting firms have safeguards in place whereby they will close your spread bets automatically to prevent this from happening, but they cannot guarantee this; if markets are extremely volatile and moving quickly it will be difficult for your spread betting firm to close your spread bets.
Being a debtor and owing your spread betting firm money is not a situation any trader would want to find themselves in but it can and it does happen because traders fail to understand the nature of margin i.e. they buy too much. The lesson here then is to not to buy too much exposure and to remember how leverage works.
The question of how much exposure to buy or how to go about formulating risk management techniques is beyond the scope of this work; an entire e-book could be dedicated to this question.
In fact, in the near future, I expand on this very topic because risk management (how much) is more important to success in the markets than entries (when to buy) and exits (when to sell).
I am not alone in the belief that risk management is more important to a trader than entries and exits; if you do some reading, you will find that successful traders come to the same conclusion.
Often these traders will quote position sizing or volatility as means by which they can reduce the risk of losing. In regards to not buying too much exposure, some traders will determine the amount of money that they are prepared to lose before each and every trade using well known formulas and stop losses .
I have a policy of tieing stop losses on every single trade and would not trade without them . The point is that at the very least, traders ought to be using stop losses to deal with the dangers of leverage.
Now that I have thoroughly convinced you that spread betting is the root of all evil, complicated and just too much to deal with, it would be a good idea to re-evaluate the advantages of spread betting.
The advantages to spread betting are:
Search results from Google will yield a list of websites that provide demo spread betting accounts free of charge for as long as you like. In demo accounts you are able to trade the markets in exactly the same way as you would with real cash.
At the time of writing (May 2011), there is no capital gains tax to pay on the profits of spread betting unlike traditional share trading. Tax laws can of course change at any time.
Shares are charged 0.5% stamp duty on any purchase of shares. Mark would have had to pay the Government £20 for the privilege of investing in Vodafone in our example above.
If you know how to use it, leverage gives small account holders access to the financial markets unlike traditional share trading.
Unlike traditional share trading, you can make a profit on the value of shares going down instead of up if you use a spread betting account.
As we have seen, commissions can vary in price between traditional stock brokers. Commissions can mount up as a significant cost, especially if you are an active trader.
Spread betting successfully requires good risk management , patience and time.
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Spread betting benefits Spread betting is tax-efficient, you do not have to pay any stamp duty. There is no commission charge you have to pay when trading spread betting. Because the profit of spread betting companies comes from the spread they offer. Spread betting is a leveraged product so you put down a small amount of money while controlling a large value trade. This indicates that potential profits are magnified as well as your losses. You can access 24h markets. In the UK spread bettings are tax-free. You can trade them in any mar
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Is Spread Betting Leverage

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