Spread betting explained

Let's be upfront here.

Spread betting is risky. It's high octane. It's not for widows and orphans.

But say you have a hunch that the euro is on the verge of collapse. Or that the Japanese stock market will beat the US market this year. Or that the banking sector is long over due another crisis.

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Spread betting is one of the easiest and cheapest ways for a private investor to back their hunches with hard cash. And if you call the market right, you can make big profits, very rapidly.

What is spread betting?

Spread betting simply allows you to speculate on whether the price of an asset will rise or fall. You can gamble on everything from shares and commodities to stock market indices and house prices.

The beauty is that you don't actually have to buy the underlying asset you want to trade. You just take a view on the prices offered by the spread betting provider as to whether the price will rise or fall.

How spread betting works

Spread betting firms offer you a quote, which consists of a bid (selling) price and - slightly higher - offer (buying) price. Take the following example. If the FTSE 100 stands at 4700, the spread betting provider will likely offer you a bid price of 4698 and an offer price of 4702.

If you think that the index will rise, you might "buy" for £10/point at 4702. For each point the FTSE 100 rises, you will earn £10. Say the FTSE rises to 4722 by the day's close, and you decide to close out your bet. Your profit will be £200 (4722-4702 = 20 x £10). In contrast, if you think the market will fall, you "sell" at 4698.

But there are risks as well as rewards in spread betting. Although you can make a lot of money from wagering a small stake, you can lose money fast, too. So if you sell the FTSE 100 for £10/point at 4698, and it actually rises to a spread of 4720/4724, you lose £260 (4698-4724 = -26 x £10).

Because you can quickly lose lots if your trade goes wrong, spread betting firms demand some protection that you'll eventually be able to settle up. This is a deposit called 'margin'. It varies in size, but is usually around 10% of the value of your bet. If your losses on the trade threaten to exceed that margin, your provider will demand more money, known as a margin call. If you can't come up with this, the provider will close out your position at the current price.

You'll go broke quite fast if you depend on margin calls to control your losses. So a much better way is to use stop losses. These are orders to close out a trade at your specified level. In the above example, if you sold at 4698 but set a stop loss at an offer price of 4710, your loss would be just £120 (4698-4710 = -12 x £10).

There is a potential problem with ordinary stop losses however - "gapping". That's where the market is moving fast and lots of stop-loss orders are triggered together. Since they close at the market price closest to the specified price on a first-come, first-served basis, you may not get out at the level you expected.

The solution to this problem is slightly more expensive but well worth considering the guaranteed stop. Here you pay your broker a slightly wider spread to get you out at a preset price regardless of how many other stop orders are triggered alongside yours. In effect your broker is buying you out of the trade. At times of high volatility in particular, that's insurance that's well worth paying for.

What are the advantages of spread betting?

One reason is the tax break. Under UK law, there are no taxes on your betting profits, either stamp duty or on capital gains. Another is that it can be an easy and cost effective way to trade. When you buy shares through a broker, you have to pay a fee. With spread betting you don't. This is because the spread betting provider makes his money from the difference between the bid and offer prices.

But it's not just about cost. Spread betting lets you speculate on a whole range of markets that would otherwise be difficult to access. For example, as well as betting on currencies and shares, you can bet on how many seats a political party will win in a general election, or how many runs a cricket team will score in its innings.