Don’t lose your shirt on spread betting and CFDs

Almost 100,000 people placed a spread bet in the UK last year. Not only did that make this the UK's most popular trading method, it also made the UK the world's largest spread-betting market.

Spread betting is popular because it offers an easy way to go short (bet on falling prices) and to use leverage (trading with borrowed money in the hope of earning higher returns). However, while it can be a useful tool if you're experienced enough, it's also easy to run up large losses. To see why, let's take a look at an example.

Spread betting the FTSE

Say you believe that the FTSE will rise from its current position at 6,400. A spread-betting firm quotes you a bid price of 6,399 and an offer price of 6,401. Because you believe the index will rise, you buy at the offer price of 6,401.

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First, you have to decide on the size of your bet. This is measured ipounds per point how much a trader is set to gain or lose for every point the index moves. Let's say you bet £10 per point. Your spread-betting provider will require you to put up some money to cover the risk of you losing this is known as "margin". The amount of margin varies between firms and bets, but let's assume you need to put up 2% of the bet's face value. In this case, that's 6,400 x £10 x 2% = £1,280.

The market opens and unfortunately the FTSE tumbles 100 points. Realising you've made a bad call, you close the trade as quickly as possible by selling at the latest bid price, which is 6,299. Your total loss is (6,401-6,299) x 10 = £1,020 and your margin has been almost totally wiped out. If you'd decided to keep the trade open instead, your provider would have demanded that you put up more cash to cover your deepening losses.

Manage the risks

As this example demonstrates, spread betting is definitely risky and it's easy for unwary traders to lose everything. So if you are tempted to start spread betting, you need to master risk management right from the outset. Entire books have been written about risk management, but there are two simple principles to master early on. First, limit the amount you're prepared to lose on each bet to a small proportion of your capital. In the example above, we effectively bet our entire account on a single bet. That's madness. Second, use stop losses to enforce those limits. A stop loss is an order to close the trade if it goes against you by more than a certain amount. In our example, we might have set a stop loss at 6,391.

If the FTSE dropped below this, our trade would automatically have been closed, limiting our loss to around ten points (£100 or 10% of our account capital in this example).

Choosing a provider

Spread-betting firms don't charge commissions; instead, their charges are built into the spread between the bid price and the offer price. The wider the spread, the more your provider is charging and the harder it will be to make money. So when choosing a firm, check their typical spreads on the markets you plan to trade.

Lastly, always remember that it isn't easy to make money from spread betting. So sign up with a demo account (most major providers offer these) and practise trading in this. Winning with hard cash at stake is far harder than paper trading. If you can't make money consistently and manage risks sensibly on paper, you shouldn't even consider committing real money.

Contracts for difference: what are they?

Spread betting is the most popular way for retail investors to short or make leveraged trades. But more advanced traders may prefer to use a contracts for difference (CFDs). Like spread betting, trading CFDs involves margin and leverage, and CFDs are offered by most of the same firms that offer spread betting. But there are several key differences between the two.

Tax: unlike spread bets, CFDs are subject to capital-gains tax. That might sound like a disadvantage for CFDs. However, the downside of spread-betting gains not being taxable is that losses can't be offset against any other liabilities you may have. That can be a problem. Say you want to use a short position on the FTSE 100 to hedge your stock portfolio against a potential decline in the market. You want the tax status of your short trade and your portfolio to match. If your portfolio is in a taxable account, rather than a tax-free account such as an individual savings account, a CFD will often be a better choice.

Currencies: if you make a spread bet on a non-UK market, you won't have any foreign currency exposure (you're simply betting how much an instrument will move). But a CFD is valued in the currency of the market it's made in. If you bet on the S&P 500, your bet will be valued in US dollars. Depending on your view of the prospects for the currencies, the exposure inherent in CFDs may be an advantage or disadvantage.

Charges: as explained above, spread-betting providers' charges are built into the bid/offer spread. CFDs usually trade with explicit commissions when you buy and sell (typically 0.05%-0.1%) and a daily financing charge to reflect the money you are borrowing from the broker as leverage. This means that CFD charges are more transparent than spread betting. In general, spread betting is cheaper for very short-term bets or small amounts. But if you plan to trade a large sum, or keep trades open for longer, CFDs are likely to be more cost-effective.