Gearing Up – Spread Betting

Gearing Up – Spread Betting

Spread betting is perhaps the simplest form of derivative trading around and is certainly the most tax-efficient. Spread bets allow you to bet that the price of an underlying asset (a share, commodity or index) will rise or fall. This means that you could hedge your existing holdings, perhaps betting on a fall in the FTSE 100 to offset the risk of a fall in your UK portfolio.

You could also use spread betting to speculate on your view of an underlying asset (a share price or index level, for example), either trying to profit from a falling price or hoping to make enhanced gains from a rising price. Betting on falling prices is known as ‘going short’, whereas betting on rising prices is called ‘going long’.

The great advantage of spread betting is that gains are totally free from tax. This means you do not have to pay capital gains tax at 40 per cent (for higher-rate taxpayers) on gains over the annual exempt allowance, which is currently £9,200. On the other hand, you cannot offset any losses from spread betting on gains made elsewhere.

Spread betting is also very flexible and allows you to choose risk levels to suit your own circumstances. This is because the higher the degree of gearing (magnification) you use in the hope of boosting returns, the more your profits or losses will be enhanced.

For example, you could set your gearing level at 10 times (10-1), where your profit or loss would change by 10p for every point move in the FTSE 100 index. If you were more confident (or could stand to make a larger loss), you could gear up by one thousand times, where every point move by the FTSE 100 would create a £10 change in the value of your bet.

Although spread bets can be kept open for several months, you must leave a deposit (known as margin) with your broker. A typical minimum margin level would be around £2,000. However, if you are making a loss on your position, you must top up the margin every day – although you do not have to keep the bet open for as long as you intended at the outset, of course.

If you bet on a rising price, you can make unlimited enhanced profits. And, if the market moved against you, your losses would be enhanced but capped, as the underlying price could fall no further than 0p.

On the other hand, if you bet on a falling price, your potential profits would be enhanced but limited. And if you bet on a falling price and it rose, your losses could be unlimited – hence, the need to top up your margin (on any day you lose money) acts as a break and could force you to close a disastrous position, instead of racking up enormous losses, which would only be settled at the close of the bet.

You can also restrict your potential downside by setting a stop-loss with your broker. This would close your position, if the underlying price moved against you and past a predetermined level (falling 10 per cent below its opening price, for example).

Stop-losses should not be set too tight, though, as the underlying price could move against you before changing direction, so you do not want to be closed out too early. You can also use a trailing stop-loss, which keeps the same percentage-point distance but follows a rising underlying price up in a bull market, enabling you to lock-in some gains.

Spread-betting providers set their own spreads, which are not necessarily the same as the bid price and offer price for an underlying share. So spreads can be set much wider for spread betters (although, in theory, competition between brokers should keep spreads fairly tight).

In reality, though, underlying spreads on some shares can be as wide as 5 per cent, although they are normally much tighter for large, frequently-traded shares. This is because the wider the spread, the larger the movement required by the underlying price for the bet to pay off.

You go long with a spread bet by ‘buying’ the underlying asset at its offer price and close it by ‘selling’ at the bid price. To go short, ‘sell’ the underlying asset at the bid price and close by ‘buying’ at the offer price.

The only difference is in foreign-exchange trading, sometimes known as forex, which is a form of spread betting. Currencies are always shown in pairs and you buy the one you think will perform better. For example, if you think the dollar will fall relative to sterling, you need to buy sterling (versus the dollar).

To conclude spread betting is great fun, and almost anyone can enjoy the odd bet now and again. But if you want to make money from spread betting, then it must be taken seriously and a disciplined and tactical approach is required.