The possibilities of spread betting are obvious, but getting started is often daunting for the first-time trader. The process of placing a bet can seem very different to buying and selling shares, bonds or funds, requiring you to learn a whole new world of jargon. So in this article, we'll take you through how a typical spread bet works.
Our first trade
We could bet on anything from Apple shares to the price of zinc, but we'll start with something that any British investor will be familiar with: the FTSE 100 index. This stands at 6,650 at the time of writing and we believe for the purposes of this article that it's likely to rise. So we want to place a trade that will profit from that.
We log in to our spread betting account and see that our spread betting provider is quoting two prices for a bet on the FTSE 100 a bid price' of 6,649.5 and an offer price' of 6,650.5. The bid is the price at which we can sell (known as going short') and the offer is theprice at which we can buy (known as going long'). The difference betweenthe two prices is called the spread'.
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It's from this that spread-betting firms make their money although due to tough competition between providers these days, the spread should be relatively small, at least for major markets such as the FTSE 100.
If we want to bet that the index will rise, we buy the FTSE 100 at the offer price of 6,650.5. First we need to decide how much we want to bet, in terms of pounds per point'.
This determines how big our gains or losses will be for each point the FTSE 100 moves. We're going to bet £10 per point. So if the FTSE 100 rises to 6,660.5 6,661.5 (in terms of our provider's quote), we make £100. But if it falls to 6,640.5 6,641.5, we lose £100.
Understanding leverage
We'll go through exactly how that's calculated in a moment. The important thing right now is that you can immediately see how spread betting involves leverage'. 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 for our provider (because they don't want lots of broke clients who can't pay what they owe).
Our provider will manage their risks by demanding margin'. This 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. It also sometimes varies depending on market conditions essentially, the more volatile our bet will be, the more margin the provider will demand.
For a bet on a major index, the typical margin is about 0.2% of the value of the face value of the bet. In this case, we opened a £10 per point position on the FTSE 100 at 6,650, giving it a face value of 6,650 x 10 = £66,500. Take 0.2% of this and you get £133, so that's the minimum amount we'll need on deposit in our account to make this bet.
So now our bet is open. Let's assume it goes in our favour. The FTSE 100 rises 50 points from 6,650 to 6,700 and our provider is now quoting a spread of 6,699.5 6700.5. Spread bets automatically run until their maturity date', which is when the bet 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 before that date. In this case, we have a decent profit, so that's what we'll do. We close out the bet at the current bid price, for a gain of (6,699.5 6,650.5) x 10 = £490. (Remember that for a long bet, we open the bet at the offer price and close it at the bid, while for a short bet we open it at the bid and close it at the offer the spread always works in the provider's favour, not ours.)
We've decided to close our bet before it reaches its maturity date, but in another situation we might want to keep it running longer. Many types of spread bet can be rolled over' before they expire there will be a charge for doing this, but it will usually be less than the cost of closing out the current bet and opening a new one.
Limiting our losses
Obviously, we've shown a good profit of £490 from a quick 50-point change in the FTSE, but the bet could easily have gone the other way, and we'd owe money to 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 known as a margin call'. If we don't have enough money in our account to cover this, our provider will shut the position, forcing us to take the loss.
The important thing to note here is that the margin system is designed to protect the provider, not the client. If we rely on hitting our margin limit to close out trades that go wrong, we'll lose money very fast.
Right from the outset, we need to be rigorous about risk management to make sure we don't burn through our deposit before we've got to grips with how to be a profitable trader. We look at some things to bear in mind here if you're to have any chance of making money from spread betting.
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