Pros and cons of spreadbetting

Spreadbetting can make money irrespective of whether markets are rising or falling. However, the leveraging inherent in spreadbetting that can magnify your gains can do the same to your losses. The spreadbet is not an investment strategy for the faint-hearted.

With spreadbetting, rather than buying an asset, you bet on the movement of an asset's price, either up (going long) or down (selling short).

The minimum stake for many assets is £1 per point. "A bet of £1 per point gives you exposure to 100 shares," says Angus Campbell, head of sales at Financial Spreads. "If the share price moves 1p or 1 cent, you make £1. If it moves in the opposite direction to your bet, you lose £1 for every 1p or 1 cent."

To cover you for any losses if the market moves against you, you'll need to put down a margin. This is also known as a notional trading requirement or deposit factor and is usually a percentage of your exposure.

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The amount you need to put down depends on the volatility and liquidity of the underlying asset. David Jones, chief market strategist at IG Index, explains: "We'll require a 5% margin for FTSE 100 shares, but the margin will be 25% on some smaller UK shares."

Multiples are set for some assets. For example, on an index such as the Dow Jones, IG index sets a deposit factor of £200 per point.

Positions can be open for as long or as short as you like. Paul Dimambro, head of HL Markets at Hargreaves Lansdown, explains: "There are different types of bet, most commonly daily and quarterly. You don't have to hold them until the end of the period, but the spread will increase with the time frame to reflect the additional broker costs.

"If you decide to hold a bet open past its expiry date, you can roll it over, although there will be additional costs involved that will be factored into the spread."

You can also place orders on your spreadbet to help manage the risk. The most common of these is the stop-loss, which automatically closes your position when the price falls to a set level.

Jones explains: "A stop-loss manages the risk on the downside. We don't charge for these. If the price falls dramatically overnight and opens below the stop-loss price, it will close at this price. A guaranteed stop-loss, which is paid for through a wider spread, closes at the price you set whatever happens."

Other orders allow you to perform a range of functions, including taking profits when a higher price is hit or buying at a set price. 

MULTIPLE STRATEGY

Spreadbetting can be deployed in a number of ways. Short-term speculation is the most common use – traders may go into the market for a matter of seconds to make money on price movements.

The leverage offered by spreadbetting is highly attractive, as you only need to tie up a small amount of money to get the same gain as a share deal that could tie up a lot of money.

Hedging is another common use for spreadbetting. Dimambro explains: "Say you are holding a large number of shares. They've increased in value significantly, but you think they're going to fall in value.

"However, if you sold them, you'd trigger a capital gains tax liability, so you take out a spreadbet, going short and matching your exposure to the real shares. This way, if the value does fall, you won't lose out."

You can also use spreadbetting to hedge against other assets. For example, a farmer facing a poor harvest might want to go short on wheat to reduce the impact of losing money on his crop.

Likewise, as John Horlock, head of trading at Cantor Index, explains, you could use them to hedge the currency market.

"If you're buying a property abroad or need a large amount of foreign currency in the future but you're worried the exchange rate will move against you, you could take out a spreadbet going short on the currency you want to buy so that you don't lose money," he says.

GEARED EXPOSURE

Leveraging is the key benefit of spreadbetting. "Spreadbets provide geared exposure, so you need less money than if you were holding the asset. For example, putting down a margin of £200 could provide £2,000 of exposure," says Adrian Lowcock, senior investment adviser at Bestinvest. 

Another attraction is that there is a diverse range of tradable investments. These include UK, European and US shares, bonds, sectors, indices, currencies and interest rates, as well as commodities such as oil, wheat and pork bellies. On top of this, trading hours are longer, with 24-hour trading available on assets such as currencies.

A further selling point of spreadbetting is that it's tax-free. There is no stamp duty on purchases and no capital gains or income tax for UK residents.

This means you don't need to worry about including profits on your tax return, although, if you make losses, you won't be able to offset them against other gains.

One final benefit of a spreadbetting is that there is no commission to pay.

SIGNIFICANT RISK

The big disadvantage of a spreadbet is its potential to lose money. While this is also possible when you invest in shares or collective investments, because spreadbetting uses leveraging, losses can be magnified.

Lowcock explains: "Many people are attracted by the large tax-free gains that can be made, but you risk losing your whole investment and more. You can bet on margin so you could lose money you don't have."

Spreadbetting companies look to minimise this and will issue margin calls if your losses are close to exceeding the margin you set, and some will close positions if you slip into the red. You can put guaranteed stop-losses in place yourself so that your losses don't become too large.  

GETTING STARTED

As spreadbetting offers greater potential for losses than share dealing, you might want to try it out before committing to a full-blown account. Some spreadbetting companies, for example Financial Spreads, offer demonstration accounts that allow you to play the market without losing a penny.

Others, including IG Index and Hargreaves Lansdown, have a limited-risk account for new clients. This minimises risk by setting a lower minimum stake, typically 10p per point, and offering guaranteed stop-losses that can limit your losses.

Many spreadbetting companies will vet you by assessing your investment and sharedealing experience to make sure you are suited to spreadbetting.

Campbell adds: "We do reject people, although if they're still keen to try spreadbetting, we would suggest our demonstration account to gain experience and then that they reapply."

Another important point to remember when starting out is that, although a huge variety of investments are available, it's worth sticking with what you know.

Dimambro says: "Many people open an account and trade all sorts of things they've never traded before. The more successful traders watch a handful of investments and only trade them."

This article was originally published in Money Observer - Moneywise's sister publication - in September 2010