Spread betting allows you to profit from the ups and downs of many different financial instruments, including shares. But it's not for the faint-hearted...
Although I've been investing in companies for 23 years, I've been spread betting for only two years. The reason for this 21-year gap is very simple: buying shares in well-managed businesses is far less risky than betting on the future direction of financial markets.
Patient investing usually pays off
When you're investing in company shares, time is on your side. Over time, if a company does well, then its profits should rise, leading to higher dividends to shareholders and a rising share price. Although share prices can be highly volatile, especially in troubled times, capturing your share of the long-term growth of British businesses is a patient process. Ideally, your timescale for investing should be ten or more years.
A ride on a rocket
Then again, compared with investing, spread betting is a wild, adrenaline-fuelled ride in a rocket. Spread betting allows you to make tax-free gains by betting on the future direction of financial instruments, including individual shares, indexes (such as FTSE 100), bonds, currencies, commodities and even house prices. You name it, if there's a market, there's a spread bet for it.
As well as being free of Capital Gains Tax (CGT), spread bets allow you to take positions using leverage. In other words, as with buying a house, you don't have to pay the full price. Instead, you put down a deposit, rather than fully paying for a bet. For liquid (easily traded) shares in large companies, such as blue-chip FTSE 100 firms, your deposit can be as low as 5%.
In addition, unlike investing, spread betting allows you to profit from falls as well as rises in asset prices. This means that you can 'short' using spread bets and profit when prices fall. Given that the stock market has plunged over the past two years, shorting has become an increasingly attractive pastime among spread betters. Alas, when shares go through one of their periodic leaps, shorters are often left nursing burnt fingers!
A dangerous gamble?
In my view, the biggest problem with spread betting is the number of people who are attracted to it as a means to 'make a quick buck' or 'get rich quick'. This means that the turnover of spread-betting clients is very high. Indeed, anecdotes suggest that 80% to 90% of new spread betters get wiped out by losing 100% of their initial stake. Thus, gambling addicts and raw recruits often end up 'churned and burned'.
Another problem with spread betting is that you need to get quite a few things right for your bet to pay off. You need to bet in the right direction, get your timing right and choose the right-sized bet. Thanks to gearing (the magnification of your position using leverage), you can suffer large losses when you get any of these three factors wrong.
Here are six more things you should be aware of before spread betting:
1. Overall, spread-betting is a losing game
As with all companies, spread-betting firms make their money by picking their customers' pockets. In other words, the majority of a spread-betting firm's profit comes from money milked from, and losses run up by, its customers. For example, leading spread-bet outfit IG Group (LSE: IGG) made a pre-tax profit of over £111 million in its latest financial year. So, taken as a whole, spread betting is a losing game for punters and a winning game for financial bookmakers.
2. If you use leverage, then you must have liquidity
Betting using leverage is dangerous. If you bet on a share using a 10% deposit, then your exposure to the underlying movement of said share is increased by a factor of ten. So, if a share price suddenly falls 20%, then you lose double your initial stake. At this point, your spread-bet provider will call or email you, demanding a sizeable 'margin call' -- more stake money to support your bet.
If you can't meet your margin calls (sometimes, extra money must be deposited that day), then your bet will be closed and your profit or loss will be crystallised. So, if you bet using leverage, then be sure to have plenty of liquidity. In other words, keep plenty of spare cash on deposit to meet margin calls at a second's notice.
3. A wrong-sized bet is a big mistake
In 2007, during my early days of spread betting, I had a strong run of winning bets. As my profits mounted, I saw myself as a skilful and gifted spread better. However, readers of Nassim Nicholas Taleb's excellent book Fooled By Randomness would see my problem immediately: my success may have been entirely down to dumb luck!
I got my comeuppance on what I now dub 'Kerviel Day'. European markets went into a nosedive in January 2008 on news of a €4.5bn loss by rogue trader Jérôme Kerviel at French bank Société Générale. With share prices dropping 10% or 20% at market open, I took a hiding, losing more than £10,000 within minutes of the London Stock Exchange opening.
This setback taught me a valuable lesson. In hindsight, I realise that I was taking too much risk, simply because my bets were too large. As the amount of leverage I was using was far too high, I cut back my positions and increased my liquidity. Later in the year, when markets started to plunge after the collapse of Lehman Brothers, I was much better prepared and didn't take a nasty bath.
In short, don't get too fond of leverage and watch your liquidity, or a wrong-sized bet could take you to the cleaners. Today, leverage adds only 5%-ish to my total stock-market exposure.
4. Watch out for changing margin rates
In times of increasing volatility, punters lose a packet and spread-bet companies worry about bad debts. That's why they can change margin rates at a moment's notice (although they usually give punters a week or two to stump up more cash).
For example, in February 2009, IG Index decided to increase its margin rates, almost across the board. In my case, I had two weeks to increase the margin on every bet I held. The margin on my largest bet soared from 25% to 75%, meaning that I had to triple my initial stake money. Fortunately, since Kerviel Day, I kept a large cash cushion, so I was able to avoid my bets being closed out for lack of margin.
5. Be aware of how spread-bet firms make their money
Spread-betting firms make money in a variety of ways. If they don't hedge your bets (offset your position in the wider market), then they win when you lose -- and vice versa. Also, they charge you 'funding interest' on your bet (say, around 5% a year), either through a daily charge or by adjusting the price of your bet. Also, they add on a margin above the usual market spread, so a share priced at 100p to sell and 102p to buy might be 99p to sell and 103p to buy via a spread bet.
These charges really add up, so keep an eye on them. I use four different spread-betting accounts in order to shop around for the best combination of spreads, margin rates and so on.
6. Be prepared for a rollercoaster
Spread betting is not for the faint-hearted or foolhardy. The combination of gearing, market timing and bet direction can be toxic for punters. It's all too easy to get into trouble and run up large losses when you're wrong. Even using stop losses (guaranteed exit points) can prove costly when markets are swinging like a pendulum.
If this sounds at all risky or complicated, then spread betting probably isn't for you. Stick to long-term investing instead!
> For a gentler ride, try The Motley Fool's Share Dealing service. Opening an account is free and real-time trades cost just £10.
