Leveraged trading with spread betting and contracts for difference (CFDs) isn’t for everyone. It certainly won’t form the core of a strategy for most MoneyWeek readers. However, for some people, short-term trading can be a useful supplement to your longer-term investments. Gains can be tax-free with spread betting, although not with CFDs. Stronger regulation, especially around leverage and negative balance protection for retail investors (so you can’t end up losing more than is in your account), have also reduced the risks of some of the horror stories of traders suffering large losses that were more common during the early days of these markets.
However, leveraged trading is still risky. It is called “spread betting”, not “spread investing” for a reason. When I was spread betting before I joined MoneyWeek, I ended up learning some hard lessons about the importance of controlling losses.
Here are five tips that should help you when starting out. This advice won’t guarantee your success, but it will at least cut the risk of racking up losses that you can’t afford. It will also help you think about whether your expectations are realistic enough.
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1. Spread Betting: where to start with trading
How much "disposable" money do you have?
The first thing to do when starting out in trading is to work out how much available money you have. This is money that you can afford to lose. A good rule of thumb is that the amount "at risk" should form only a small part of your investment portfolio – no more than 5%. You should never spread bet with borrowed money, or money that you need to pay the bills, under any circumstances.
Do you have enough capital?
No trading strategy is perfect, and sooner or later you will hit a run of bad luck. Some professional traders suggest that you should risk no more than 1% of your pot per trade, which implies that the total pot should be 100 times bigger than the size of each trade. While this may seem excessively cautious – especially if you don’t trade that often – I wouldn’t stake more than 10% of your trading fund on each trade.
Having less capital will restrict the type of trading that you are able to do. For instance, if you want to spread bet the FTSE 100 at 50p a point (the minimum at many providers), having a limit of £100 per trade will mean that you can only absorb 200 points worth of losses before you need to close the trade – so you are likely to be very focused on short-term trades.
Providers will also require you to have a minimum amount of money in your account to back each trade. The exact amount you require varies between markets and is usually expressed as a leverage ratio (eg, 5:1) or a margin requirement (eg, 20%) of the face value of the trade. For example, if you are trading a market that has a leverage ratio of 5:1, you will need £100 in capital to open a position with a value of £500.
Overall, if you can’t afford a trading fund of at least £4,000, then spread betting might not be for you.
2. Come up with a trading plan
Trying to trade without a strategy is a certain route to failure, so you should come up with a trading plan before putting your money at risk for the first time. This should detail the factors you will use to decide when to buy and sell. It should also include more general things such as the markets you will be trading in, whether you will be going both long and short, or long only, and the length of time you will hold positions. The plan should also include the amount of time, energy and money that you are willing to commit to spread betting.
For instance, do you want to trade every day, or are you going to just check your positions for an hour or so every week or so? Are you going to do lots of research on potential trades, buy the latest trading software or stick to a simple system that requires minimal updating? All these things are worth considering, and the process of writing things down will force you to clarify things in your mind before you start doing things for real, as well as checking whether your plan is realistic. For example, day-trading multiple markets isn’t a good idea if you work during the day and have an active social life. Finally, a plan can serve as a reminder of what to do when you eventually start trading.
3. Look at a range of providers
There are a large number of spread-betting firms offering the ability to spread bet over the internet, each with pros and cons. However, there are three things that you should look for:
Regulation
First, you want to make sure they are properly regulated by the UK Financial Conduct Authority (FCA). FCA regulation comes with a series of protections (such as negative balance protection) and will give you up to £85,000 worth of protection if the firm holding your money goes under (though, obviously, this won’t compensate you for any losses you make due to poor judgement).
Markets
You should also make sure they offer the markets you want to trade in. While virtually all the main companies offer things such as the FTSE 100 and the dollar/sterling exchange rate, coverage of more obscure markets varies, so check what is listed on your chosen provider’s website before signing up.
Size of spreads
Another key variable is the size of the spreads – the difference between the buy and sell price. Since spread-betting firms don’t charge upfront fees, they make their money on the difference between the buy and sell price, which can eat into your capital over time. Everything else being equal, lower spreads work out to smaller costs, so you are looking for a provider that offers tight spreads in your chosen markets.
4. Open some demo accounts
At this stage, you may be raring to go. However, many spread-betting firms allow you to practise with a demo account for free. For instance, IG’s demo account simulates trading with a capital of £10,000, as well as running various seminars walking you through the process of trading. You may think that this is only for complete beginners, and it’s true that nothing can fully prepare you for the experience of risking your own money. However, practise accounts can help you make sure that you are comfortable with the strategy that you have selected, (as well as with spread betting in general) and fine-tune your approach.
At the very least, using a demo account, and taking the time to read through the documentation provided, can get you familiar with the controls so you don’t end up accidentally placing a much larger bet than you intended, and can take advantage of all the features available. One key feature that should become a part of your process is learning to use stop losses.
5. Always use stop losses
Stop losses are a crucial weapon in the armoury of spread bettors. They work by instructing the spread-betting firm to close a position that is going against you if it falls below a certain point (in the case of long positions) or rises above it (in the case of short positions). Many long-term investors don’t like stop losses because they force you to close your positions. However, when it comes to trading, where every price movement against you has a direct impact on the bottom line, it is a very different story. Despite the rules limiting leverage and eliminating negative balances, it’s still possible for a sudden move to end up taking a large chunk out of your trading capital.
Even using an ordinary stop loss may be insufficient in certain circumstances. During periods of high volatility, the market may suddenly jump from one price to another without stopping at a point in between. If this happens, the stop loss will not trigger at the price you set it at. For example, assume you are trading the FTSE 100 at £1 a point and your stop loss is at 6,500. If the market suddenly fell from 6,501 to 6,480, because of some bad economic data, you would end up losing £21, rather than just £1. The only way to get around this is to use a guaranteed stop loss, which triggers at the point at which you had set it. This comes at an additional cost (sometimes called the stop premium) that is charged if your stop loss is triggered.
This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
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