Key rules for avoiding disaster when spread betting

When we placed our first spread bet, we did something extremely careless that will have any experienced trader shaking their heads: we didn’t set a ‘stop-loss’. While not every trader uses these, most successful ones do – and beginners certainly should.

A stop-loss instructs our spread betting provider to close our bet once it goes against us by a certain amount.

In our previous example, we could have set a stop-loss at 6,630, meaning that if the FTSE 100 falls below this, our bet will be closed and our loss should be limited to 20 points (£200 here).

We say ‘should’ because stop-losses are not completely secure. Sometimes – especially in volatile and illiquid markets – the price can ‘gap’ past your stop-loss before it triggers, leaving you with a larger loss than expected.

However, you can pay for ‘guaranteed stop-loss orders’, which means your provider commits to closing your position at the specified price even if the market gaps. This will cost a little more – reflected in a wider spread – but the added certainty can be valuable, especially if you are still getting to grips with spread betting.

Three risk management rules

Stop losses are key to managing risks, but they are just one tool. Risk management is about your entire trading process, not just having an automated way of getting out of losing bets. While it may not sound the most exciting part of trading, risk management is an absolutely vital skill to master.

Traders who survive and profit in the longer term are invariably successful, because they manage the risks from losing trades, not just because they have great ideas for winning trades.

Different traders have different systems. For example, John C Burford, who writes our free MoneyWeek Trader email, sums up his philosophy in three simple rules:

• The golden rule: Preserve your account equity. In other words, avoid losing a significant chunk of your initial deposit.

The 3% rule: Never risk more than 3% of your capital on any one trade. This means closing your position once it’s down by 3% of the total value of your account. John recommends setting a stop-loss when you enter the trade to ensure this happens automatically.

The break-even rule: Move your stop-loss to break-even as soon as possible – ie, once your trade is sufficiently in profit, move your stop-loss up so that if it suddenly reverses, your position is closed at no loss. Most spread-betting firms now offer the option of ‘trailing stop-losses’ that will move the level of your stop-loss up or down to lock in profits.

Following rules like these for capping losses is a good idea when you’re just started out. Ultimately, you may develop and refine your own system, but your first priority is to avoid losing your entire deposit while you’re still getting to grips with the basics. Adopting a prudent, tried-and-tested set of rules to follow makes that a lot easier.

Why traders get into trouble

Even the best set of rules won’t help you if you break them. Most traders who get into trouble do so because they stick (and even add) to losing positions in the belief that they’ll turn around.

So once your stops are in place, treat them as inviolable. And don’t bet too much on any one trade. This is especially important when trading markets with very high leverage on offer, such as FX.

How safe is your money?

Most spread betters who lose money do so because of their own mistakes. But the other risk is that your spread betting provider collapses, taking your capital with it. This is rare, but it has happened in the past, so it’s useful to understand a bit about investor protection.

Money belonging to a spread betting firm’s clients is held on trust: the firm cannot use it to fund the running of the business. If the firm goes bust, its creditors can only go after its own cash, while yours will be returned to you. To ensure ownership is clear, client money is segregated from firm money by being ring-fenced in specific accounts.

That’s great in principle, but a determined fraudster can always find ways to siphon off money, while the temptation for management to dip in to client assets when a firm is on the brink can become too much.

For worst-case scenarios, there’s the Financial Services Compensation Scheme (FSCS). If you have a claim against an authorised financial services firm that the firm cannot meet, the FSCS will pay compensation. For spread betting, the limit is £50,000 per person per firm.

Obviously, you hope you’ll never need to call on the FSCS, especially if you need your money quickly – it can take months to pay out. So think carefully about which company you choose – pick a solid, stable one, rather than focusing solely on those offering the lowest spreads or highest margin.

And never deal with any of the unregulated offshore brokers who aggressively target unwary traders. If you do, you have no protection from the UK regulator, or access to the FSCS, if something goes wrong.