The average casual investor thinks of buying shares as the primary means of investing in stock markets. This is not without reason. Most people who play the stocks do so by actually buying shares. Still, there is another way to go. Rather than buying the underlying security, investors can bet on its movement. This form of investing is known as spread betting and has tax benefits in the UK.
Spread betting is pretty big here in the UK. It is so big, in fact, that spread betting platforms for UK traders abound. But is this form of investing better than actually buying stocks and shares? It has its upsides, but spread betting has its downsides as well. You can make and lose money – just as you can buying securities.
A Basic Definition
In a generic sense, spread betting is betting on the outcome of a particular event based on a spread tied to some means of measurement. Spread betting in the stock market is essentially betting on the movement of a particular stock. You place a bet based on whether you think the price will increase or decrease over a set amount of time.
If you bet correctly, you make money. Bet incorrectly and you lose. It is quite simple in principle. One of the advantages of spread betting is that you can get into it with less money than would otherwise be required to purchase the security in question.
How Spread Betting Works
Spread betting is common on stock markets. You can also bet on commodities, currencies, and even fixed-income securities. The type of security becomes irrelevant because you are not actually purchasing it. Here’s how it works:
You choose a stock you are interested in. You decide whether you think the price is going to rise or fall over a set amount of time. You then place a bet on that decision. Let’s just make something up – the Generic Stock Company (GSC).
GSC is currently trading at a bid price of £100. You believe it’s going to fall to £90 over the next several days. You decide to bet £1 on every point below the £100 mark as represented by the ask price. Then you wait. If the ask price falls to £95, the difference between the original bid and the current ask is five points. Multiply those five points by your £1 bid and you have made a profit of £5.
Profit and loss are determined by multiplying your bet by the point difference in either direction. If GSC were to increase to £105, you would have lost £5.
Obviously, people who spread bet as a means of making money in the stock market generally deal with much larger sums of money. This is important because spread betting platforms require minimum deposits based on margins.
How Margins Work
In a traditional stock market investment, you might borrow money from a brokerage in order to buy securities. An investor typically has to put some of their own money in too, similar to making a down payment on a house. The difference between the investor’s money and the amount borrowed is known as the margin.
At any time, the brokerage could call the margin. That means the investor would be required to either repay what was borrowed or deposit additional funds to raise their account value.
A margin in spread betting is a little bit different. Rather than being money contributed in conjunction with a brokerage loan, it is simply a percentage of the security’s value. So let’s say your broker’s margin on GSC is 10%. Before you can place your bet, you would be required to deposit £10 – i.e., £100 x 10%.
Volatility Rules the Day
There are people who love spread betting because it doesn’t cost them a whole lot, comparatively speaking, to get in on the action. A 10% or 20% margin is a lot more doable than paying full price for a security. The downside is volatility. It rules the day in the spread betting arena.
At issue here are margin calls. Inexperienced investors who do not know what they are doing could lose a bundle by taking positions they cannot possibly support with limited deposit accounts. For this reason, experts suggest not putting more than 2% or 3% of your investment funds into spread bets.
Along those same lines, spread betting firms have been known to protect themselves during periods of excessive volatility by widening their spreads.
More About the Spread
Spread betters appreciate that there are no commissions on spread bets. Instead, brokerages make their money on the spread. The spread is the difference between the bid and ask price. Using the previous example, imagine GSC’s bid price is £100 and its ask price is £102. The spread is 2% of the ask price, or £2.
If you are thinking GSC will fall, you place your bet on the ask price. The difference between the eventual ask and the starting bid is the spread on which your profit is derived. The brokerage earns the difference. If you think GSC will rise, you place your bet on the bid price. The difference between the eventual bid and the starting ask is the spread on which your profit is made. Again, the brokerage makes money on the difference.
Big Gains and Losses
As for whether or not spread betting is a better way to make money in stocks, that really depends on your appetite for risk. The fact is that spread betting is open to significant gains and losses. You could make a bundle just as easily as losing your shirt. But you have to be willing to take a significant risk.
The danger of spread betting is its limited amount of time. You are betting on movement over days or weeks. On the other hand, buying a security is open-ended. You can hold onto it for as long as you want. That way, if its value falls tomorrow, you can hold until it regains those losses and earns more. You can hold for 20 years if that’s what it takes to derive the profit you’ve been hoping for.
While it’s possible to take a long-term position with spread betting, doing so is not necessarily in your best interests due to the ever-present potential of a margin call. Most spread betters deal in short-term contracts lasting no more than a few days or weeks.
Yes, you can make good money spread betting. You can also lose big. In the end, it boils down to your appetite for risk.