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, let's dig into how a typical spread bet works.
How to place your first trade
You could bet on anything from Apple shares to the price of zinc but, in this theoretical example, let's start with something that any British investor will be familiar with: the FTSE 100 index. This stands at 8,327 at the time of writing and we believe (for the purposes of this article only) that it's likely to rise. So we'll place a trade that will profit from that.
Step 1
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.
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- A bid price of 8,326.5 and
- An offer price of 8,327.5.
The bid is the price at which we can sell (known as "going short") and the offer is the price at which we can buy (known as "going long"). The difference between the two prices is called the spread. 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.
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Step 2
If we want to bet that the index will rise, we will buy the FTSE 100 at the offer price of 8,327.5. 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 8,337.5, 8,338.5 (in terms of our provider's quote), we make £100. But if it falls to 8,317.5, 8,318.5, we lose £100.
Understanding leverage and spread betting
We'll go through exactly how leverage is 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 spread betting 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 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 8,327, giving it a face value of 8,327 x 10 = £83,270. Take 0.2% of this and you get £166, so that's the minimum amount we'll need to 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 8,327 to 8,377 and our provider is now quoting a spread of 8376.5 to 8377.5. Spread bets automatically run until their "maturity date", which is when the bet expires and we take our winnings or settle our losses.
Note: 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 the bet 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 (8,376.5-8,327.5) 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.
How to limit your 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 you rely on hitting your margin limit to close out trades that go wrong, you'll lose money very fast. Right from the outset, you need to be rigorous about risk management to make sure you don't burn through your deposit before you've got to grips with how to be a profitable trader.
