FOOL'S EYE VIEW
The Dangers That Lurk Beneath Spread Betting

By David Kuo (TMFDragon)
March 28, 2002

Carburton Street, London -- With such colourful characters as The Plumber, The Spaniard and Evil Kenevil in the frame it is not surprising that spread betting has caught the imagination of the general public. The Plumber, also known as Paul Davidson, was a major shareholder in Cyprotex (LSE: CRX), which floated last month on AIM, the Alternative Investment Market. He placed a £6m bet, through a spread-betting firm, that the share price of the biotechnology outfit would rise after the flotation. His action prompted the spread-betting company to hedge their bets by buying up almost 80% of the outstanding shares on the open market. This forced up the price of the shares but now investors are reportedly keen for the FSA to conduct an investigation into the situation.

Incidents like this can give the stock market a bad name. Alternatively it can draw unsuspecting investors into the world of spread betting. But what exactly is spread betting and how can it have such a pronounced affect on a company's share price.

Spread betting has been around for donkey's years and is simply another form of gambling. Its relationship with the stock market is purely coincidental and no one should be under any kind of illusion that spread betting is any way or shape an investment in itself. It is widely used as a form of entertainment, to help liven up an otherwise less than inspring game of football or cricket. The principal attraction of spread betting over fixed odds gambling is the almost unlimited gains that can be made. The converse is also true and unwary punters could find themselves losing an unlimited amount of money.

With fixed odds gambling, both the odds and the amount of money a punter is prepared to stake limit the upside as well as the downside. So if the odds on England winning its next Test match were offered at 4/5, a punter would win £4 for every £5 staked. Losses are also limited to amount that the punter is prepared to put down. However ,the losses encountered with spread betting can be virtually open ended. Let's take that cricket match again, but this time in relation to a spread betting quote on the number of runs the England team will score in its first innings. A typical quote might be 300-320. This is in effect a prediction by the spread-betting company of how many runs England would score. If you think the prediction is about right then there is no need to bet at all.

However if you believe England could score more than 320 runs you would then make an "Up Bet" or "Buy" at the upper limit of 320. This is also known as "going long". The amount you want to stake is within your control and you might decide to risk, say, £1 a run. So if England went on and scored 400 runs you would have won £1 for every run above the 320 upper limit. This means you would be £80 better off. However if England were dismissed for 250 you would have lost £70 on your bet. That is £1 for every run below 320.

Sounds simple doesn't it. But the Up Bet is only one of two possible bets that a punter can make on that spread. The other bet is known as the Down Bet and this is very much riskier. Let us assume that you don't believe England will score anywhere near 300 runs. You can then decide to place a "Down Bet" or "Sell" at 300. This is also known as going short. Again the stake is up to your discretion. So if you went for £1 a run and the England team was run out for 250 you would have won £50. That is £1 for every run below 300.

However, should the England team hit one of those rare purple patches and scored 500 runs you would be facing a deficit of £200 or £1 for every run above 250. In this example, the loss you might incur is obviously limited to some extent by the practical limits on how many runs can be scored in a game.

There are also mechanisms to help you limit your losses but this just means placing another bet to cancel out the first one. It is also possible to take your profits on an event before the game has officially ended. This is because spread betting quotes can change depending on how the game is progressing. This also requires placing a counter bet to cancel out the first bet.

Spread betting is now widely used to allow punters to bet on the movement of say stock market indices and also the share prices of individual companies. The main selling point is the tax-free aspect of spread betting. Winnings are free of both capital gains tax and also income tax. It is also very much easier to 'short' a stock using spread betting than it is to try and do so through a stockbroker. However the same dangers of unlimited losses that applied to shorting the outcome of a sporting event also applies to equities and indices. Also because share prices and indices can be that much more volatile the consequences can be quite devastating should things go wrong.

The conclusion must therefore be to treat spread betting as just another form of gambling and not to confuse it with investing. All gambling activities are designed to benefit the bookie and therefore the expected return for the bookie is positive. This therefore means a negative expected return for the punter. This should be contrasted with investing which produces a positive expected return for the investors over the long term.