Side step the taxman with spread betting

Spread betting offers you a tax-free, short-term alternative to buying and selling assets. But it's not without risk - here's what you need to know.

The growth of online trading has made investing far more affordable than it was in the days when the only option was placing trades over the phone via a traditional stockbroker.

But even though costs have come down significantly in recent years, commissions remain high enough that small, short-term trades are rarely cost-effective. If you're interested in this aspect of trading, you may want to consider spread betting instead.

When you place a spread bet, you don't actually buy the underlying shares you simply bet on what will happen to their price. This means that it's no substitute for long-term investment most spread bets run for just days or weeks.

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But it is a very powerful tool for short-term positions, especially since spread bets incur no stamp duty or capital gains tax on profits.

Making a bet

To see how spread betting works, let's take a look at a typical bet. The FTSE 100 is currently at 6,550 and we believe the market is likely to drop. Our spread-betting provider is quoting two prices for a bet on the FTSE a bid price of 6,549 and an offer price of 6,551.

If we want to bet the FTSE will fall, we must sell at 6,549 and if we want to bet it will rise, we must buy at 6,551. The difference between the two prices is called the spread hence the term spread betting.

In this case, we're betting that the FTSE will fall, so we'll be opening our short at 6,549. First, we need to decide how much we want to bet, in terms of pounds per point this determines how big our gain or loss will be for each point the FTSE 100 moves.

We're going to bet £10 per point. This means that if the FTSE drops to 6,5376,539 (in terms of our provider's quote), we make £100 but if it rises to 6,5576,559, we lose £100.

We'll go through exactly how that's calculated in a moment the important thing right now is that you can see that spread betting involves leverage. This means that we're borrowing money from the provider when we make our bets. This magnifies our potential gains, but also our potential losses.

Leverage makes it important to manage risks both for us (because we don't want to go bust) and our provider (because they don't want lots of broke clients who can't pay what they owe).

Putting up margin

Our provider will seek to manage its own risks by demanding margin, which is the deposit we need to place to back our bets.

Exactly how much margin we need to put up depends on what we're betting on and on what market conditions are like essentially, the more volatile our bet will be, the more margin the provider will demand.

A typical margin is about 10% of the face value of the bet. In this case, we opened a £10 per point position on the FTSE at 6,550, giving it a face value of 6,550 x 10 = £65,500. Ten per cent of this would be £6,550, so that's what we need on deposit in our account.

So now our bet is open. Let's assume it goes in our favour. The FTSE drops 50 points from 6,550 to 6,500 and our provider is now quoting 6,4996,501. Spread bets automatically run until a maturity date, which is when it expires and we take our winnings, or settle our losses this could be a day, a week, a month, or however long the particular bet we've entered into is.

However, we can choose to close it at any time beforehand. In this case we're showing a decent profit, so we'll choose to do so. We close out the bet at the current offer price, for a gain of (6,549-6,501) x 10 = £480. (Remember that for a short bet we open the bet at the bid price and close it at the offer, while for a long bet we open it at the offer and close it at the bid the spread always works in our provider's favour.)

Obviously, we've shown a good profit on our initial deposit of £6,550 but the bet could have gone the other way and we'd owe moneyto the spread-betting firm. That's why we had to put up margin.

If the bet keeps running against us and our potential loss piles up, our provider will demand we put up more margin. This is known as a margin call.

If we don't pay in extra margin, our provider will close out the position at the current price, forcing us to take the loss.

Managing your risks

The important thing to note here is that the margin system is designed to protect the provider, not us. If we rely on hitting our margin limit to close out trades that go wrong, we'll lose money very fast. We need to do our own risk management and that's where the final step in our bet comes in.

We need to set a stop-loss an instruction to the provider to close our bet once it goes against us by a certain amount.

In this example, we're going to set a stop-loss at 6,570, meaning that if the FTSE goes through this, our position will be closed and our loss should be limited to 20 points.

We say should' because stop-losses are not completely secure. Sometimes especially in volatile and illiquid shares the price can gap past your stop-loss before it triggers, leaving you with a larger loss than you expected.

However, you can pay for guaranteed stop-loss orders, which means that your provider commits to closing your position at the specified price even if the market gaps.

This will cost you a little more reflected in a wider spread but extra certainty can be worthwhile, especially when you are getting started.