How to use this weapon of mass destruction

Do you spread bet? It’s become hugely popular among private investors in recent years. And though it can be very risky, I’m a big fan of it myself.

Today I want to take you through the pros and cons of being a spread better. Because spread bets can offer things that simply aren’t available elsewhere to the average private investor… and at a great price. And seeing as I want to show you a few trading ideas over the coming weeks, you might want to consider how spread betting could enhance your portfolio.

I’ll say right off: it’s right to be wary. There’s no doubt that when used badly, these accounts can be financial weapons of mass self-destruction. But there are serious benefits to trading this way.

Let’s start with the pros…

Three great reasons to spread bet

The first thing I would say is that spread betting can be quite a tax efficient way to trade. Capital gains tax (CGT) on trading profits normally kicks in after you’ve made more than £10,600 profit on your investments. But spread bets are exempt from CGT. So for anyone fortunate enough to be regularly paying tax on trading profits (ie, making more than £10,600 a year in profits), it may well be worthwhile considering using a bet, rather than a traditional broking account.

But given that most investors can use Isas and pensions to achieve the same tax advantage, tax probably isn’t the main reason for using financial spread betting.

It’s more likely to be the appeal of not having to pay commissions or brokers’ fees that private investors find attractive. With a spread bet, you pay the ‘spread’. Let me explain by way of an example.

If you want to buy BP shares for instance, you can buy them through your traditional broker at £4.62, at the time of writing.

Or, you could use a bet to buy a contract expiring in March for £4.63, June for £4.65, or September for £4.67. You don’t have to stick with these positions until they expire… the dates represent when the bet is settled.

As you can see, the longer the bet, the more you pay by way of spread. The extra spread is the bookie’s profit. And it usually works out as something like 1% to 2%. Now, if you look at this as a cost of financing your position, then you’ll see that it’s actually quite an attractive proposition. I mean, where else can you effectively borrow money at those sorts of rates?

Now, I’ve chosen a big blue chip stock here. It’s worth noting that less liquid stocks will attract larger spreads (as they do if you buy through a normal broker). Personally, I wouldn’t use a spread bet for these smaller, illiquid stocks. The reason is that when the contract expires, if you want to keep your position, you’ll have to pay the spread again. It’s known as the cost of ‘rolling over’ your position. So be aware of these costs. The bigger the spread, the more you pay!

You’ll have to work out the benefits of not paying commission (and stamp duty) versus the cost of the spread and rolling over your position each time the contract expires.

The third benefit to spread betting is the leverage you can get. As I’ve just shown, these bets can offer an economic way of financing a position. Again, let’s use BP to explain…

BP is quoted in pence, so if I want to get £4,670 of exposure, I could bet £10 per point on the September 2013 contract. The quote is 467 pence, multiply that by £10 (per point – or penny movement in the share price), and you get your exposure.

Now, I may only have to put down a 20% deposit with the spread bet provider. So in this case I’m asked that I fund my account with at least £934. Sounds great, doesn’t it? I’ve got nearly five grand’s worth of exposure by only putting down about a grand. And the effective finance cost through the spread is only about 1% or 2% a year.

BUT beware. If the stock falls, I’ll be expected to pony up more money so that my position always maintains that 20% margin.

This is what often catches investors unawares. Far too often a downward lurch in a share price leads to margin calls, and if they’re not met, the position is closed out automatically. In the worst case, you can lose 100% of your deposit! And even if you don’t, you can get closed out at a loss, only to find the share bounces back and leaves you out of the trade and booking a loss.

So approach spread betting with great caution! Always leave enough cash on the account to fund margin calls!

If you can get over that…

But so long as you are aware of your total exposure and keep an eye on your account, then you should be alright. I suspect that most punters that come a cropper do so because they don’t understand the inherent leverage in operation (ie, you’re only putting down a small percentage of your overall exposure) and aren’t able to meet margin calls.

Worse, if they’re overleveraged, they’re more likely to get panicked out of a position at exactly the wrong time. Staring at a big loss starts to get very emotional!

Now, if you’re happy using leverage, and you’re fully aware of the concept of spread betting, we can look at some of the other benefits…

First, you’ll be able to get exposure to all sorts of things normally out of the reach of a private investor. You can go short or long and most accounts allow you to put in advanced instructions on how to execute orders. For example, if a stock is trading at £1.10, you can put in an order that says buy when the stock falls to £1.05, and then sell it if it bounces back to £1.12.

You can get exposure to gold futures, oil or hogbacks – heck, even UK house prices. All with the click of a mouse.

Of course, all these exotic trades can provide the uninitiated with as many opportunities to hang themselves as they provide opportunities for the more sophisticated. But in my opinion, used wisely, spread bets can offer a great way of diversifying your portfolio at limited cost.

The other great advantage is the free charting tools at your disposal. I won’t go into detail here, but in future issues, I’d like to show you how to use some simple charting techniques to help formulate a trading strategy. As I said last week, by my reckoning, we’re going to see plenty of volatility and market swings this year. The central planners are fighting the markets every step of the way. Markets want to deflate, but the planners want them inflated.

So up and down we go! It’s a trader’s paradise. If we can get our strategy right, then there are bound to be some great opportunities out there. And in my opinion, the spread bet is often the most efficient tool we have to make the most of these opportunities.

If you’re not already familiar with spread betting, you can take a look at my colleague John Burford’s free video tutorials and you can sign up to receive his e-letter MoneyWeek Trader. When you feel ready to get started you can compare account providers.

I’ll be reviewing some strategies over the coming weeks, so stay tuned for that.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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  • Ian

    John Burford’s e-mails have got me very interested in spread betting so it will be good to get another perspective. I am looking forward to your views with much anticipation!

  • Orb

    Bengt, with respect, you have not highlighted the risks with some statistics, the most important of which is that (last time I researched) more than 85% of spread-betters LOSE money in these accounts.

    It’s worth highlighting what are considered 3 VERY important character traits to possess before entering the spread-betting domain: Discipline, Patience and Consistency.

    The last vital requirement before spread-betting is to fully understand trade sizing.

    Some advice: ignore what the educators tell you and DEMO trade first to prove your strategy works and build confidence.

  • MichaelL

    If you think there is volatility and want to limit your downside, you can buy a straddle (two options, your risk is limited to the premium paid on the two), think spread-bet firms will allow you do buy the straddle in one transaction, i.e. doubt you have to manually do both options. probably not something you want to be doing with your retirement fund though – and its speculating of course, not really investing.

    As an investor, maybe its worth looking at the returns for absolute return hedge funds – now compare their returns with a vanguard tracker over 10 years.

    You can guess which one comes out on top.

  • Aff

    I have to admit being interested in dabbling in this despite my better judgment warning me it is simply a form of gambling. Can anyone recommend an easy way to get started? How small can your initial investment be? I like the idea of demo trading as mentioned in the comment above

  • Richard Warmington

    Spread betting has proved to be very lucrative for me and my wife Emma Jowett. But maybe that places me in the top 15pc and there has been an element of luck!

  • Keith

    The majority of day traders (and spread betters) lose – why? Because most traders are under-funded and will stick to opening large big positions on a few markets. This explains it all in detail:

  • Orb

    Aff @4, Niall Fuller’s site ‘learntotradethemarket’ is popular with many budding spread-betters. Babypips is also useful as a jargon buster and more. Dailyfx provides some good blogs, useful info and even free webinars where you get to ask questions.

    You need to try out a few trading accounts. The most popular UK-based one seems to be IG Index, but personally I don’t rate them; they don’t offer a demo account either. For me it’s all about transparency and visibility through the trading platform and no-one has been able to show me an improvement on FXCM’s, although they are more expensive and deal primarily with currency trading.

    Beware of ‘information overload’ – you need to develop and stick with a focused plan/strategy that works consistently. And I certainly recommend DEMO trading to start with.

  • Orb

    Well done Richard and Emma. Perhaps the statistics have changed in recent years? Maybe you did a fair amount of research to start with? Or are you seasoned ‘closet economists’/or investers?

    There can be an element of luck involved sometimes (it is leveraged gambling after all): my initiation saw a 5000% rise (yes, five thousand) inside 3 months! That was before learning about trade sizing… you can guess what happened next: I trashed the account over the next year through several margin calls!

    After educating myself properly, I’m happy to stick to aiming for 100% a year; anything more is a bonus.

    And Keith @6 is absolutely right; consensus seems to be that you are increasing your risk of losing if you aren’t prepared to start with at least £2k, and that has to be money you are comfortable writing off as ‘education expenses’.

  • David Craig

    You don’t mention that some spread-betting companies have systems that block you closing out your position if you win on too many trades. They then let you close your position when you fall into a loss. This happened to me witha well-known spread-betting company – it’s little short of fraud