What Is Spread Betting?

Spread betting is a derivative strategy, in which participants do not own the

underlying asset they bet on, such as a stock or commodity. Rather, spread bettors
simply speculate on whether the asset's price will rise or fall, using the prices offered
to them by a broker.

As in stock market trading, two prices are quoted for spread bets—a price at which
you can buy (bid price) and a price at which you can sell (ask price). The difference
between the buy and sell price is referred to as the spread. The spread-betting broker
profits from this spread, and this allows spread bets to be made without
commissions, unlike most securities trades.

Investors align with the bid price if they believe the market will rise and go with the
ask if they believe it will fall. Key characteristics of spread betting include the use of
leverage, the ability to go both long and short, the wide variety of markets available
and tax benefits.

Origins of Spread Betting

If spread betting sounds like something you might do in a sports bar, you're not far
off. Charles K. McNeil, a mathematics teacher who became a securities analyst—and
later a bookmaker—in Chicago during the 1940s has been widely credited with
inventing the spread-betting concept. But its origins as an activity for professional
financial-industry traders happened roughly 30 years later, on the other side of the
Atlantic. A City of London investment banker, Stuart Wheeler, founded a firm named
IG Index in 1974, offering spread betting on gold. At the time, the gold market was
prohibitively difficult to participate in for many, and spread betting provided an easier
way to speculate on it.

Despite its American roots, spread betting is illegal in the United States.

A Stock Market Trade Versus a Spread Bet

Let's use a practical example to illustrate the pros and cons of this derivative market
and the mechanics of placing a bet. First, we'll take an example in the stock market,
and then we'll look at an equivalent spread bet.

For our stock market trade, let's assume a purchase of 1,000 shares of Vodafone
(LSE: VOD) at £193.00. The price goes up to £195.00 and the position is closed,
capturing a gross profit of £2,000 and having made £2 per share on 1,000 shares.
Note here several important points. Without the use of margin, this transaction would
have required a large capital outlay of £193k. Also, normally commissions would be
charged to enter and exit the stock market trade. Finally, the profit may be subject to
capital gains tax and stamp duty.

Now, let's look at a comparable spread bet. Making a spread bet on Vodafone, we'll
assume with the bid-offer spread you can buy the bet at £193.00. In making this
spread bet, the next step is to decide what amount to commit per "point," the variable
that reflects the price move. The value of a point can vary. In this case, we will
assume that one point equals a one pence change up or down in the Vodaphone
share price. We'll now assume a buy or "up bet" is taken on Vodaphone at a value of
£10 per point. The share price of Vodaphone rises from £193.00 to £195.00, as in the
stock market example. In this case, the bet captured 200 points, meaning a profit of
200 x £10, or £2,000.

While the gross profit of £2,000 is the same in the two examples, the spread bet
differs in that there are usually no commissions incurred to open or close the bet and
no stamp duty or capital gains tax due. In the U.K. and some other European
countries, the profit from spread betting is free from tax.

However, while spread bettors do not pay commissions, they may suffer from the
bidoffer spread, which may be substantially wider than the spread in other markets.
Keep in mind also that the bettor has to overcome the spread just to break even on a
trade. Generally, the more popular the security traded, the tighter the spread,
lowering the entry cost.

In addition to the absence of commissions and taxes, the other major benefit of
spread betting is that the required capital outlay is dramatically lower. In the stock
market trade, a deposit of as much as £193,000 may have been required to enter the
trade. In spread betting, the required deposit amount varies, but for the purpose of
this example, we will assume a required 5% deposit. This would have meant that a

much smaller £9,650 deposit was required to take on the same amount of market
exposure as in the stock market trade.

The use of leverage works both ways, of course, and herein lies the danger of spread
betting. As the market moves in your favor, higher returns will be realized; on the
other hand, as the market moves against, you will incur greater losses. While you can
quickly make a large amount of money on a relatively small deposit, you can lose it
just as fast.

If the price of Vodaphone fell in the above example, the bettor may eventually have
been asked to increase the deposit or even have had the position closed out
automatically. In such a situation, stock market traders have the advantage of being
able to wait out a down move in the market, if they still believe the price is eventually
heading higher.

Managing Risk in Spread Betting

Despite the risk that comes with the use of high leverage, spread betting offers
effective tools to limit losses.

• Standard Stop-Loss Orders: Stop-loss orders reduce risk by automatically

closing out a losing trade once a market passes a set price level. In the case
of a standard stop-loss, the order will close out your trade at the best available
price once the set stop value has been reached. It's possible that your trade
 can be closed out at a worse level than that of the stop trigger, especially
when the market is in a state of high volatility.
• Guaranteed Stop-Loss Orders: This form of stop-loss order guarantees to
close your trade at the exact value you have set, regardless of the underlying
market conditions. However, this form of downside insurance is not free.
Guaranteed stop-loss orders typically incur an additional charge from your
broker.

Risk can also be mitigated by the use of arbitrage, betting two ways simultaneously.

Spread Betting Arbitrage

Arbitrage opportunities arise when the prices of identical financial instruments vary in
different markets or among different companies. As a result, the financial instrument
can be bought low and sold high simultaneously. An arbitrage transaction takes
advantage of these market inefficiencies to gain risk-free returns.

Due to widespread access to information and increased communication,

opportunities for arbitrage in spread betting and other financial instruments have
been limited. However, spread betting arbitrage can still occur when two companies
take separate stances on the market while setting their own spreads.

At the expense of the market maker, an arbitrageur bets on spreads from two
different companies. When the top end of a spread offered by one company is below
the bottom end of another’s spread, the arbitrageur profits from the gap between the
two. Simply put, the trader buys low from one company and sells high in another.
Whether the market increases or decreases does not dictate the amount of return.

Many different types of arbitrage exist, allowing for the exploitation of differences in
interest rates, currencies, bonds, and stocks, among other securities. While
arbitrage is typically associated with risk-less profit, there are in fact risks associated
with the practice, including execution, counterparty, and liquidity risks. Failure to
complete transactions smoothly can lead to significant losses for the arbitrageur.
Likewise, counterparty and liquidity risks can come from the markets or a company’s
failure to fulfill a transaction.

The Bottom Line

Continually developing in sophistication with the advent of electronic markets, spread
betting has successfully lowered the barriers to entry and created a vast and varied
alternative marketplace.

Arbitrage, in particular, lets investors exploit the difference in prices between two
markets, specifically when two companies offer different spreads on identical assets.

The temptation and perils of being overleveraged continue to be a major pitfall in

spread betting. However, the low capital outlay necessary, risk management tools
available, and tax benefits make spread betting a compelling opportunity for
speculators.