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Spreading the word
By Clem Chambers, CEO of ADVFN (www.advfn.com)
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Financial spread betting is part of a trend in trading and investment towards derivatives. Derivatives are financial instruments that are contracts whose value is based on an underlying security or value.
So for example a futures contract on gold is a derivative as it is not actually gold you are buying and selling, but a contract that has a value to the holder based on a contractual arrangement connected to the price of gold at any one particular time.
There is very little chance that either a buyer or seller of a derivative has any plan to actually take delivery of the underlying product; in this case gold. Therefore a derivative contract is more driven by the agreement between the parties to deliver and take delivery of a cash payout depending on the price of the underlying security rather than the security itself, be that a gold bar, share or currency.
Most derivatives are in fact complicated insurance policies enabling the owners of one kind of risk to exchange them for a certain outcome at a certain time. They are prepared to pay a price for this.
This charge for certainty levied on the party with a need to reduce its risk, is either matched by that party taking on another risk he is more comfortable with, or passed on to a speculator who feels the payment for taking on the risk is a good one.
The speculator is an important part of the picture as he acts as lubrication to the process whereby risks are reallocated around the markets to participants who want to bear them. As the speculator trades, he is in fact acting as an agent, passing on risks until an optimally efficient equilibrium is found.
While it might not seem obvious a spread bet is part of this rather academic picture.
A spread betting company is in essence a business offering a user-friendly interface to speculation in derivatives. A spread bet is a derivative and often it is a derivative of a derivative.
For example, a trader may think that the FTSE 100 is going to go up. He could open a Liffe trading account and buy a contract. However that contract would involve him making a £50,000 bet on the direction of the FTSE 100, because that is the minimum size of a FTSE 100 Liffe contract.
A spread betting company however will allow you to put a £1 a point bet on the FTSE 100, equivalent to a £4000 bet, because it can roll up all the exposure to these gambles in a batch and then lay this off by buying the large Liffe contract on the Liffe market. In effect, it often acts as an aggregator of many small bets, turning them into one large market position. This gives the spread betting companies the ability to offer FTSE 100 spread bets or Dax spread bets at any size you could want, which in some cases is as little as 1p a point.
Of course the spread betting company is making money from this and they make it from the spread.
At this point it is probably a good juncture to revisit some spread betting basics. A spread better offers a speculator the chance to bet long or short on wide range on financial instruments at a “bid offer spread.”
A spread might be; you can buy Vodafone at 102 and sell it at 100. For the FTSE 100 there will be a six point spread so you can buy a position at say 4006 and sell it at 4000. There is always a six-point spread between the price you can buy and the price you can sell. The spread betters therefore make a gross of six points for every completed trade. Likewise on the above Vodafone spread he will make two points on every trade, either long or short.
If you had decided to bet a pound a point on the FTSE 100, the spread betters’ fee for this position would amount to £6. This might not seem much, but at £10 a point the position costs £60 a trade, and a £100 a point costs £600 a trade.
The spread better has one trading cost: the cost of laying off his bet on the market. This might be a single point on a liquid market like the FTSE 100 or an equivalently tiny percentage on the Dow or S&P 500, so he has a reasonable margin after passing on the risk of five points.
Additionally if you have a £10 a point bet long on the FTSE and someone else has £10 a point short, the spread better has a natural hedge.
Putting this another way, you paid £6 to go long one pound a point and someone else paid £6 a point to go short, so the spread better cannot lose on these two bets in aggregate and does not have to hedge in the market for a price. Instead he has pocketed £12 and can sit back and watch both parties cancel each other out in his books.
Sadly for the spread betting company, speculators in the market are seldom in two minds, so the betting is either all long or all short and bookmakers are often forced to lay off their exposure in the market at their expense.
There are a plethora of markets covered by modern spread betting companies but most people associate spread betting with equities and indices. Today the universe of speculation has spread to currencies, bonds, interest rates, traded options, commodities and even house prices.
For a trader this is an exciting menu of opportunity. To get direct market access to all these instruments would be fabulously time consuming and expensive, whereas a spread better for what is a modest tariff opens up all these avenues with a single online account.
Dabbling in Libor futures is not for the faint hearted but nonetheless market access in its own right is an asset even if you never take a position. For example with an open account, you will never miss that opportunity to make a killing in say a particular currency, just because it would take you a couple of weeks to open a currency trading account.
For equities the benefits are more obvious. There is no stamp duty on a spread bet. For an intraday or active trader, a 0.5% tax is a nigh on impossible hurdle to vault. A trader must look to being shielded from this expensive barrier and can do so with a spread bet.
This is a tax advantage that CFDs (contracts for difference) also enjoy but spread betting has a spectacular added tax benefit. There is no taxation on profits from spread betting, unless the revenue can prove you are a pro.
Cynics are quick to point out that you must first make a profit, but it is a certainty that no one speculates with a plan to lose their money, so this tax break is an extremely attractive feature.
Another attractive feature of spread betting is leverage. To the non-gambler, leverage is not a benefit but a demonic temptation. On average, a spread better will give an index speculator 20 times leverage, that is to say if you want a £1 a point exposure to the FTSE which is worth £4500 of exposure, you can have it with £225 down.
Of course if the market runs against you, you may soon be called upon to top up your account. However, the upside potential of leverage if you are right can be immense. This is a very compelling feature for those with either absolute faith in their judgment or as some might suggest, a lack of understanding of the fundamentals of risk.
If a punter puts £225 into his account and then takes a £1 a point bet on the FTSE and the market goes up 225 points in a month, he will double his money. It does not require recourse to Excel to work out the impact of doubling your money each month. At that rate a little money becomes a lot of money in a relatively short period.
Sadly it is remarkably hard to be consistently right and high leverage can act very much against a speculator’s chances. The laws of over-betting means they will most probably get forced out of their position by a contra-move caused by general volatility. This leaves the speculator out of the game for good even though his position might be proved to be generally correct in the long run. The impact of leverage on a step in the wrong direction proves as powerful in destroying capital as creating it.
The thing to remember about leverage though is that it is not compulsory to use it. As with any tool, understanding its impact and its range of applications can turn it from a blunt instrument into a useful device.
Spread betting has more applications then it is often credited with and is generally thought of as a trading or short-term investment tool. However, underlying the creation and use of derivatives is the concept of hedging.
For example, anyone with a sizable portfolio might reach a point where they are very worried indeed that the market might crash. Traditionally they have few options but to sit tight or sell out. The trouble with selling is that the costs can be significant. Brokerage charges, spreads and perhaps even the crystallisation of tax liabilities make selling out a drastic move.
Let’s say the portfolio in question was worth £1,000,000. Getting in and out might cost 2% brokerage, 0.5% stamp duty and 1% spread, that is £35,000. Getting out of the market to reenter later is therefore an expensive manoeuvre.
Yet by selling £50,000 worth of stock and lodging it with a spread better, the whole portfolio could be hedged against the FTSE 100 for three months for around £1400. For a few hundred pounds more another three months could be tacked on.
It would of course be an expensive pain if the market continued to go higher, but once again powerful tools should not be wielded lightly.
One of the downsides of spread betting is that it is easy to misunderstand the risks and costs. For example the spread and therefore cost of a FTSE 100 or a Dow spread bet can seem small. Because of this many will try and trade the intraday moves of an index in order to capture very short-term moves. However if you crunch the numbers it becomes clear that the spread represents around 10% of the daily range of the index price.
This is a high barrier to jump to make a profit and the possibility to profit in the long run starts to shrink horribly if you were to trade several times a day. Likewise contracts are of a finite period - renewing contracts quarterly can add up to a big cost. Personally on equity spread bets I take, where possible, longer-term contracts, which on a per day basis work out cheaper than short period bets. Timing is notoriously difficult to judge and moves, even when you are right, very often take longer to occur than expected. Like most serious trading or investment, cost controls can be as important as risk management in delivering final returns.
Few spread betters understand the capital at risk that leverage gives them. I have spoken time and time again to active index “traders” who are aghast when I explain that their £50 a point on the Dow is a £500,000 capital at risk position. Of course the market volatility means that they are infinitely unlikely to lose £500,000 on that position, but markets have and will again drop 25% in a day or two. With an understanding of capital at risk, disaster can be avoided but the user friendliness of spread betting can lull people into a false sense of security.
However, any serious investor or trader should have a spread betting account. The sheer breadth of markets that can be accessed via today’s online spread betters is a feast for anyone with a head and heart for speculation. While certainly not for the inept or tyro, spread betting is an extremely flexible, cost effective and user-friendly way to gain access to the biggest games in town.
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