Spread betting gives private investors the opportunity to make big gains on small stakes if they back a winner. It also enables them to make money from a falling share or index.
The risks involved are high, though. Make a bad call or have some bad luck and you can quickly end up with some eye-watering losses. Here's what you need to know to get started.
What is spread betting?
When you place a spread bet, you are not buying anything real as you would be if you bought the shares of a company. In fact, it's very similar to placing a bet with a bookmaker.
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Instead of betting on the winner of the 3.30 at Newmarket, you are in this case betting on where the price of a share, a stock-market index, a barrel of oil, exchange rates or interest rates might be at some time in the future.
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One benefit of spread betting is that you can bet on the prices of shares or commodities going up or down. When you bet that an index or a company's shares are going to go up, this is called going long' on the shares or index. Betting that they will go down is called going short'.
Spread bets are usually rolling (this means they can be closed at any time), or may have a fixed time period on them, such as three months.
How do you make money?
Let's use the real-world example of BP shares. The spread-betting company might give you a selling (bid) price of 489.6p and a buying price (offer) of 490.2p. The difference between these two prices is known as the spread and is how the company makes its profit.
If you want to bet on the price of BP shares going down, you pay the bid price of 489.6p. If you think the price will go up, you pay the offer price of 490.2p. Once you've decided what you want to do, you need to work out how much to stake.
Spread bets are based on an amount of money per point. Here one point is equivalent to a 1p move in the BP share price. Say you bet £10 per point on the price of BP going up. If two weeks later the bid-offer spread is 510.2p-510.9p, you could sell at 510.2p (the bid or selling price), and make a profit of £200 (£10 multiplied by 20 points).
If the price had fallen to 470.2p-470.9p, you would have made a £200 loss on the bet.
Exposure and margin
One of the most important things to consider as a spread better and a company offering the bets is the amount of exposure involved. Exposure is essentially the amount of money at stake.
If you buy 1,000 shares in BP at 490.2p, you pay £4,902 (excluding commissions and taxes). If you buy 5,000 shares you pay £24,510. The difference in exposure is £19,608 and is fairly straightforward to work out. If the shares fall by 10% you lose £490.20 in the first instance and £2,451 in the second.
However, spread betting doesn't work like this. That's because when you make a spread bet you are not buying the shares or paying for them up front, you are simply betting so much per point on which direction the share price will go in.
From a financial point of view, betting £10 per point is effectively the same as owning 1,000 shares in the company.
This is because a 10% fall in the share price to 441.2p would produce the same loss of £490.20 (49.2 points x £10). In the same way, betting £20 per point would be the same as owning 2,000 shares. The bigger the share price and the bigger your stake, the more exposure you have.
Large exposures create big risks for the spread-betting company, because it is effectively lending its client money. To reduce these risks, you have to put up a percentage of the exposure, which is known as margin'.
A worked example
Say you are betting on BP shares going up in price at £10 per point. Your exposure is 490.2 x £10, or £4,902. The spread-betting company may ask for 10% of this (or £490.20) as margin, meaning that it is effectively lending you £4,411.80 (the effective cost of buying 1,000 shares outright).
Should your losses exceed 10% then you will be asked to put up more money. This is known as a margin call and is not something you want to be on the end of if money is tight.
This is why it is so important to consider your level of exposure. If you can't afford to cover 100% of your exposure on any spread bet you make, then you are betting too much and need to go for smaller bets.
It's also worth bearing in mind that margin requirements may increase at a time of financial crisis, such as 2008, and you will need to be prepared for this. Losses on spread bets are just like other unsecured debts and can be reclaimed through the courts if you don't pay up.
The one way you can avoid getting into trouble with margin requirements is to put a stop-loss on your bet. When the price goes through your loss level, the bet is closed and losses are capped.
A word on taxes
Spread betting is popular with investors because of its favourable tax treatment. You don't have to pay stamp duty on trades or capital gains tax (CGT) on any gains. However, you cannot use losses from spread betting to offset any gains for CGT purposes.
Hold on to the day job
While there are stories about people who have given up their day jobs to make a living through spread betting, it isn't easy to do that. You are just as likely to lose money.
Because of the risks involved, it's probably best to use only a small amount of your savings for spread betting and simply to treat it as a bit of fun rather than an investment. Don't bet more than you can afford to lose.
