Part I
Getting Started with Financial Spread Betting
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In this part . . .
Get to grips with what Financial Spread Betting really involves, and whether it’s for you.
Weigh up what you need in choosing a provider.
Grasp the basic strategies: trading long, trading short and getting the lowdown on leverage.
Deal with price slippage.
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Chapter 1
Deciding Whether Financial Spread Betting Is For You
In This Chapter
Understanding where financial spread bets fit into the financial product spectrum
Fulfilling your responsibilities as a trader
Taking the preliminary steps to trading success
Financial spread bets are financial derivatives, instruments whose prices are based on something else – such as a share price, a barrel of oil or any of a wide range of other products. From the outset, we need to distinguish between financial spread betting and other types of spread betting in the UK. Although many people are used to spread betting on sports – football, for example – financial spread betting involves betting on the movement of prices in financial markets.
Financial spread bets are popular with traders because they’re possibly the simplest of all derivatives and this makes them accessible to a very wide audience. This ease of understanding carries with it a tendency to create a false sense of security, however, which can lead to traders being overexposed and overlooking the fact that losses are largely unlimited in some circumstances (see Chapter 3 to find out how this occurs). When used properly, though, spread bets enable you to trade a vast array of products very easily and very cheaply, which can greatly enhance your profitability.
In this chapter, we explain how spread bets work and how you can use them as part of your overall investment portfolio. We also discuss using spread bets to benefit from short-term price movements in a number of financial markets, including shares and foreign exchange. Finally, we start you on the journey of understanding how best to manage your risk as a trader, since managing risk is critical to your success.
Grasping the Ground Rules
In this section, we look at the major characteristics of spread bets and some of the main points that you need to understand before starting on your spread betting journey.
So what are spread bets, anyway?
A spread bet is an agreement to pay the difference between two prices – the price at which you open the bet and the price at which you close the contract. The spread bet’s price is based on that of an underlying instrument, which varies depending on the particular bet, but may be, say, a share or foreign exchange rate. A financial spread bet is typically an over-the-counter product. This means that it isn’t traded on a centralised exchange or market like shares. Each contract involves only two parties: you (the trader, or buyer) and the bet’s provider (the counterparty to the transaction, or seller).
When you open a spread bet you do so based on current market prices. The same applies when you close the position. What makes spread bets unique when compared with many other categories of derivatives is the way that they’re priced. Other derivative products use complex formulas to determine their prices, but spread bets simply mimic the price of the underlying instrument that they track.
In essence, a spread bet puts you in a position to make a profit (or loss) from changes in the price of the underlying instrument. For example, if you enter a long trade (that is, you bet with the view that the price will rise):
If the price rises between the time the bet is opened and closed, the seller must pay the difference in value to the buyer (you). Provided costs are covered, you make a profit and the seller makes a loss.
If the price falls between the time the bet is opened and closed, the buyer (you) must pay the difference to the seller. In this case, the seller makes a profit and you suffer a loss.
Spread betting can be risky, especially when traders overuse leverage (see the later section ‘Employing leverage’) – we cover strategies for managing this risk in Chapter 8. However, spread bets also have features that make them very useful and the preferred instrument for many traders:
Ability to easily and practically short sell shares and other financial instruments: This increases your opportunity to make money from good trading strategies by allowing you to profit from falling as well as rising markets (see
Chapter 3 for more information).
Ability to trade small positions: By staking only a small amount on the bet, you can limit your risk.
Access to a wide range of products from all around the world.
Access to cost-effective trading platforms that provide you with a wide range of analytical capabilities: These include real-time pricing, charting packages and financial news.
Leverage: When you open a spread bet, you don’t have to pay the full price of the underlying product, but simply a smaller deposit known as an initial margin (see the section
‘Paying margins’, later in the chapter), so you pay only a small amount to control a much larger position.
No physical delivery or settlement of the full value of the underlying instrument.
Tax free: Because spread betting is treated as gambling by the tax authority in the UK, you don’t have to pay any tax on your profits.
No commission: Unlike share trading, few spread betting brokers charge commission on your trades. The bid/offer spread contains the cost of the trade.
Spread bets have become a very popular short-term trading product in the UK. By ‘short-term’ we mean less than one month, but the duration can be shorter or longer than this, depending on the trader. By spread betting, you’re trying to capture short-term price movements in financial markets. If you establish a solid trading methodology, you can generate profits very quickly, but – and it’s a big but – before you rush headfirst into spread betting you must consider the potential downsides that exist. The downsides include losing more capital than you invested and seeing large swings in your capital due to the over-application of leverage. Most of these downsides relate to risk management, which we discuss at length in Chapter 8.
Spread bets are a product for sophisticated traders and you need to understand the mechanics of spread betting before placing any trades. We explain more about spread betting in general in Chapters
2 and
3.
Types of spread bets
A real highlight of financial spread betting is being able to trade in a wide range of market types and geographic locations. At one time dealing in foreign shares could be logistically quite difficult, but the Internet has changed all that by giving traders online access to markets in different locations and in different time zones. Spread betting takes this one step further by allowing you to deal in products from all around the world from a single trading platform – which means you can build trading strategies for just about anything.
To give you an idea of the different markets that these bets track, here we briefly discuss the main types of spread bets. We look at each in depth in Chapters 4 to 7.
Commodity bets: They’ve been around for some time, but have become...
