The easiest way to show how a spreadbet works is with an example.

Let's say you have been keeping a close eye on Wonky Widgets plc. Its share price is currently 100p but you reckon the market isn't doing it justice and that the price will rise sharply in the next few months. In order to profit from this you could buy shares in the company or you could place a spreadbet.

A spreadbetting firm is quoting 99p-101p on Wonky Widgets. This means you can bet on how much many pence it will go above 101p (or you can bet on how many pence it will fall below 99p). The difference in these two prices is called the spread and it is one of the ways the spreadbetting company makes its money.

The spread is a cost as far as a trader is concerned. Ideally you want the spread to be as small as possible. Different spreadbetting companies may quote different price spreads at the same time, and the same spreadbetting company could quote a wider or narrower spread at different times.

Let's say you bet £5 a point on the fact that the share price will rise. This means that for every penny that the price rises above 101p you will make a profit of £5. You'd get the same profit potential from buying 500 shares in Wonky Widgets but it would cost you around £500 to buy these shares. However, your spreadbetting company will only ask you to deposit a margin payment of some 5% to 10% of this amount, i.e. £25 to £50.

If your bet goes well
Eight weeks go by and the price of Wonky Widgets does indeed rise. It climbs to 120p and your spreadbetting company is now quoting 119p-121p. You decide that it's time to close out your bet. You do this by making the reverse bet on Wonky Widgets i.e. you sell at 119p.

As you bought at 101p this means you have made a profit of 18 points. At £5 a point this comes to £90. However, you also have to pay a financing charge. Let's assume that it's 6% per annum. It's based on the overnight sterling interest rate, say 4% per annum, plus a little extra for the spreadbetting company. You end up paying £4.60 (£500*6%*56/365) in financing charges. That means your overall profit on this trade is £85.40.

To summarise:

If your bet doesn't go so well
As it happens, you weren't right about Wonky Widgets and, unfortunately, it turned out to be rather wonky after all. Eight weeks later, the price has crashed to 80p and the spread is 79p-81p. You close out your trade at 79p, taking a loss of 22 points. This costs you £110. After adding the financing charge your overall loss is £114.60, which you'll notice is much higher than £25 to £50 margin you had to put up initially. In this instance, your spreadbetting company will have already asked you to pay additional money before you closed out your trade to cover the potential loss.

Note that your losses are limited in this instance because the furthest the share price could fall to is zero. So your maximum loss would be £505 plus any financing charges.

You could also have set an automatic stop loss to limit your losses. For example, you could specify that your bet would be closed should the price hit 90p. Setting such a limit may cost you extra (in terms of a wider spread) and of course, particularly if the share is very volatile, the price could easily fall to 90p before rising above 100p again meaning that not only have you missed out on a potential profit, but that you sold at a loss as well. Nevertheless, most traders swear by a rigid stop loss that is determined when you enter the initial trade.

Shorting
Let's say you were pessimistic about Wonky Widgets and want to bet on the share price going down. You bet £5 a point at 99p-101p meaning you make £5 profit for every penny below 99p. Eight weeks go by (again) and the price has fallen to 80p with a quoted spread of 79p-81p. You close out at 81p making a profit of 18 points, which is £90.

Because you were shorting the shares you may actually receive a financing fee from your spreadbetting company. This would be at a lower rate than you'd pay if you bet that the price would rise. Assuming you received 3% per annum then you would make an additional profit of £2.30, making your total profits £92.30.

Of course, if the price of Wonky Widgets rose in this example, then you would lose money. Conceivably, the price could rise by more than 100p, meaning your potential losses are larger than if you incorrectly bet that the price would rise. It could perhaps rise to 300p or even 400p. Although this is virtually unheard of for large companies, some small, out of favour, companies can rebound very quickly. In this instance your potential losses, if you closed out at 400p, would be in the region of £1,500. Ouch!

Summary
So you can see that there is potential to make large profits and large losses in a short amount of time. At the moment, one of the main attractions is that these transactions are free from stamp duty. However, this tax treatment may change in future and it doesn't take long before the financing charges offset any saving you make in stamp duty. In this example, the stamp duty of £2.50 on the purchase of £500 worth of shares would be equivalent to roughly 30 days financing charges.

If you need further examples and information on how these bets work, then the web sites of most providers have plenty of colourful illustrations and glossy guides.