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The following is a guest post. Enjoy!
Spread Betting – How It Works and Risks Involved
Spread betting is a derivative product that allows you to trade on price movements of underlying investment products – such as indices, individual stocks, currencies, commodities, and more. You can use spread bets to speculate on price movements both up and down. If you go long, you will profit on upward movements, and if you go short, you will profit on downward price movements.
Since spread betting involves two underlying transactions, you will be quoted two prices, a buy price and a sell price. The difference between the two is the spread. The tighter the spread, the easier it is to maximize your profits since underlying prices will need to only move a small amount for you to be in profit. Equally, prices can move against you and you may encounter a loss.
How Spread Betting Works
A good example of how this works is as follows. The UK100 Index is currently trading at 5700, and the spread bet is 5700/5701 (where 5700 is the sell price, and 5701 is the buy price).
If you think the UK100 is going to rise, you buy the price, enter your bet at 5701, at a stake size of £10 per point (which is a standard stake size).
If the UK100 Index rises, your profits will rise in line with each increase on the price above 5701. So, if the UK100 Index rises to 5725, you can cash out at the new spread price of 5725/5726. As you bought to enter the spread bet, you now sell to close it at the sell price of 5725. So, your profit would be 24 points (5725-5701) multiplied by £10, so a profit of £240.
The Risks Involved
However, the downside risks apply as well, especially since this is a margined product. If the index price goes down in the example above, to say 5650, you would lose 51 points (5701-5650) multiplied by £10, equals £510. Because of this, risk management needs to play a role in your trades.
You can minimize the risks by using stop-loss orders (which close a trade after a certain price is reached), or even a Guaranteed Stop Loss Order, which guarantees the closing exit price if price move against you. Either way, pay close attention to downside loss potential.
How about you all? Have you ever investigated spread betting? If so, have you ever given it a try? How did it work for you?
Share your experiences by commenting below!
Jacob’s Thoughts – Listed below are my random thoughts as I was reading this article.
- Very interesting post here. It’s always fascinating to learn about new types of investing that are available to the market today.
- In reading this article, spread betting reminded me slightly of options, a tool I learned about while getting my finance undergraduate degree, in the respect that you do bet on either the upward or downward movement of the underlying security.
- However, spread betting is slightly different since the spread is involved, and not just the call and put prices of the option. Additionally, with spread betting, you don’t have the “option” of refraining from transacting your bet if the result is unfavorable, as you do with options.
- Personally, although spread betting is very interesting to learn about, I don’t believe it is well suited for my personal finances. This is because 1) it would not fit in my passive investing strategy / overall asset allocation with index mutual funds and ETFs, 2) it is slightly too risky for my tastes, being as that it is a margined product, and 3) I don’t believe I have the ability to correctly time markets, currency, and/or index price movements.
- As always, when learning about new investment strategies, make sure it aligns with your current long term plan and goals to make sure you stay on the right track.
***Photo courtesy of http://farm4.static.flickr.com/3622/3409354257_3f03fd9b88.jpg
