Pros and Cons of Spread Trading
Spread trades are much simpler and easier to understand and to trade compared to other derivatives such as options and warrants. Spread trading, like CFDs, also allow you to go long, or to go short. It is all nice and dandy when markets are rising but do you have a strategy to defend your investment when markets fall? Are you ready for a market correction, for example? When the time comes, few are able to sell to cash and sit and wait for things to turn -it is exceedingly difficult because there is no “buzz”, and some of us do it for the buzz…
The Main Advantages of Spread Trading are:
a) that you can trade with low stakes without having to post big margin deposits (or ideally zero margin, by using one of the account opening credits), which means you can learn a lot without blowing 10k.
b) fixed spreads on main markets, which is especially a bonus with foreign exchange.
c) When you lose, you can always say it’s the scumbag spread trading company’s fault, even though it probably isn’t, as most of them are infinitely better than they were in the bad old days.
Some turn to shorting – and spread trading allows you to do this. Going short and Going long are are terms that reflect on the price of the shares with which you are trading, if you go long, that means that you are trading on the fact that the value of the stock will rise, whilst going short, conversely is trading on the prediction that the value of the stock will drop. This is one of the most attractive features of spread bets as you can trade long and make money on a rising market or trade short and make money when the market is falling. Going short, however, when it comes to spread bets is in effect short-selling, and this means that you stand to profit from a fall in the price of an asset.
Advantages of Using a Spread Betting Company
We break down the real advantages of using a spread betting company. The advantages include the ability to employ leverage, the ability to go short, tax benefits, use as a hedge and more.
Leverage
Unlike buying the shares directly; the initial outlay required at the time that the trade is put on is a fraction of the size of the total exposure gained. This can be viewed as a deposit to protect the spread betting company against a sudden move against the investor, called initial margin.
The size of the initial margin required varies with the market and is again driven by the same factors that determine the size of the spread. An initial margin of 10% would allow 10 times (10x = 100% / 10%) the exposure for every pound put up as initial margin.
For example, the investor in the previous example could gain £1,000 worth of exposure in the stock of Company ABC by posting only £100 in initial margin.
This is known as leverage and is one of the main attractions of spread betting, as it enables a greater potential for profit for the same price move in the underlying market. The flipside of this is that it also offers the potential for any loss to be enhanced by the degree of leverage used.
Ability to go Short
Spread betting firms offer a two-way market which enable traders the ability to speculate that the price of a stock or other market will fall in price. They can do this without having to own the particular stock of interest in the first place.
Tax Benefits
The current treatment means that any profit made from spread betting firms is free from Capital Gains Tax for trades in the UK. Trading with a spread betting firm is also free from Stamp Duty – currently there is a 0.5% charge on all share purchases for UK investors.
No Additional Transaction Costs
There are no further transaction costs to pay in putting on and taking off trades, as the cost of trading is embedded in the spread. This is more of an advantage when dealing frequently in small sizes.
Hedging
In addition to speculating, spread betting also allows for an efficient method of hedging a portfolio of stocks.
Example: Hedging a portfolio of stocks.
Suppose an investor with a large, diversified portfolio of stocks that is well represented by the FTSE 100 has a bearish outlook over the next six months. Instead of selling the stocks and then repurchasing them in six months time he can use spread betting to make a short term spread bet that does the same job. This will save on transaction costs and if he bought the stocks at a much lower price than the current market price then he will also avoid a significant Capital Gains Tax liability.
Round the Clock Trading
The London Stock Exchange opens at 8:00am and closes at 4:30pm each trading day. It is already 2:30pm in London by the time the US equity markets open for trade, which carry on trading until 9:00pm London time. As international equity markets are significantly correlated you will find that when the London markets open the following morning the are usually catching up to what has happened overnight in the US and eastern markets with stock prices frequently ‘gap’-ing.
This means that the opening price already reflects any news since the market closed meaning that no profit can be made by trading the news on the open. Fortunately, spread betting companies allow trading in UK stocks after the London market has closed – although the spreads are wider to reflect the illiquidity in the underlying market (which is closed). A trader could therefore react to news as and when it is released rather than having to wait until the following morning.
Trading International and Diverse Markets
When trading international stocks or markers UK investors normally have to open a foreign currency account which will incur transaction costs. Yet the way that spread betting companies operate mean that they are able to offer traders the ability to participate in these markets but to keep their stake denominated in sterling. Therefore, trading the S&P500 index can be done just as easily as trading the FTSE100, and this can be done from the same account.
It is not just international markets that these companies quote on they also make markets in all sorts of areas such as sport, politics, house prices, tv plus other more obscure areas. Essentially, anything that attracts interest that is subject to speculation can be traded.
Simulated Trading
If you are a novice to trading most spread betting firms offer the opportunity to trade with play money allowing you to build up some experience before plunging into the deep end. This is also a worthwhile tool for experienced traders to exploit if, for example, the market they normally trade suddenly experiences a sudden change, such as a surge in volatility or if they have experienced a bad run of recent losses.
That concludes our explanation of the advantages of spread betting – have we missed anything?
Disadvantages of Using a Spread Betting Company
Using a spread betting company as part of your trading strategy isn’t risk free. We run over the disadvantages including the negative side of leverage, contract rolls, lack of income and more…
We’ve already covered the Advantages of Using a Spread Betting Company.
Leverage
It is not just profits that are magnified by leverage but also losses. It is therefore very important to have a trading plan before starting out. Also, with the ability to go short comes the potential for an unlimited loss, as theoretically the potential rise in the price of a stock is unlimited. Again, this highlights the need for a well though out trading plan.
Margining
If a trade goes against you leading to an unrealised loss then two things can happen:
- The company ask you for a margin call; or
- They close out your position automatically.
The first scenario reduces the benefit of leverage as you will be posting more capital so any profit will be lower as a percentage of capital invested. The second scenario will reduce the control you have over your trades
.
Pick the Right Instrument
Some of the markets offered by spread betting companies are automatically closed at the end of the day and re-opened the following day at the opening prices. There are two problems with this:
- You unnecessarily cross the bid-ask spread again and again;
- if you are long and the market gaps higher, then you do not benefit from the overnight move – that is, the difference between the opening price and the previous days closing price.
To overcome these issues an alternative instrument is also offered which is not automatically closed each day only to be re-opened the following day – however the spreads on these instruments are wider.
Contract Rolls
As stated above, if your strategy is to buy and hold over long periods you may be better off dealing with a traditional stockbroker because most prices are offered with a stated maturity.
An Example of Contract Rolls.
The December contract of an individual stock will cease trading on a given trading day in December and in order to carry on with your position you will have to close out the position in the December market and open up a new position in the next available month. This means that you will have to cross the bid-ask spread twice more for every roll forward. Alternatively you could just trade a far-dated month, but as this is less liquid the spreads will be wider so again the cost is higher.
Lack of Income
Some traditional investors – normally institutional investors or retirees – prefer a stock which pays a regular dividend. There are plenty of companies which cater for this demand by either maintaining the level of the dividend they pay out or ensuring that it increases steadily over time. But with spread betting, as you do not actually own the shares then you are not entitled to any dividends so there is no steady income stream. Therefore it may not be a suitable form of investment for an investor with a requirement for a regular cash flow.
No Right to Vote
As you do not actually own the stock then you will not be able to vote at AGMs or EGMs.
No Tax Relief on Losses
Any losses incurred on spread betting trades cannot be offset against profits earned on traditional forms of investment for tax purposes. This is not a big problem for a trader who focuses exclusively on spread bets as no tax is payable at all. It could pose a problem for the investor which uses spread betting as a hedge for his stock portfolio, particularly if the stock was accumulated at a low price that is sold later in the same tax year.
Financing Charge
A financing charge is applied on all long positions.
Beware of Volatility
Not so much a disadvantage exclusive to spread betting but something to be aware of: high volatility can either be a good or a bad thing as can periods of low volatility. Sharp swings in prices can turn unrealised profits into losses very quickly, whereas periods of low volatility can suck out all interest from a market. A trader needs to identify and adapt to changing market conditions.
That concludes our explanation of the risks and disadvantages associated with spread betting – have we missed anything?
With your spread betting account, you can gain access to thousands of financial markets from all over the world including shares, indices, commodities, currencies and bonds. This means that you can gain exposure to a wide range of new markets you may not have had access to before.
One of the advantages of spread bets is that there is a wide variety of shares and indexes that you can trade upon. With spreads bets you can trade currencies, commodities, global stocks at a fraction of the price of any other product. I trade local UK markets and internatioanl markets from the same keyboard, even place orders via an iPhone or Android – it is the easiest, fastest and cheapest way to trade. It is important, though, that you know the market you are trading in very well before you begin. It is possible to lose large sums of money in spread trading, and the companies that operate CFD trading, like Capital Spreads, are keen to make sure that those who trade on them know what they are doing.
In addition you can access your account from wherever you are, whenever you want via an internet trading platform, over the phone or increasingly these days via your mobile device. The major advantage of spread bets is that the commission is low, the same process on the stock exchange would require a lot more capital, and would also be subject to UK Stamp Duty that would minimise your profits. Capital Gains Tax is also not an issue as spread bets count as gambling and therefore are subject to gambling tax.
Spread bets are good because you can hold them for short periods, so in turbulent markets like the current ones you can buy or sell very quickly in order to try and turn a profit. There is no need to hold them and hope that your investment will mature. The flip-side of this, of course, is that they are bad value for long-term investors.
Spread betting in itself is also relatively easy to understand and it is very easy to trade. The price of spread bets will move as the actual stock price moves. The fact that you are trading on margin means that you only need a small percentage of trading capital to open up sizable positions in the market. Some spread betting markets may only require 5% margin and for most spread traders the ability to trade on margin is one of the biggest attractions of spread bets as it increases the opportunity to make profit using a small capital. Though, it must be remembered that this cuts both ways in that leverage magnifies both potential profits and losses.
Spread bets also pay dividends on rolling long positions in a similar way to dividend paying shares. Spread betting brokers even pay the dividend amount immediately, which is good as you don’t have to wait for weeks as with some brokerage companies. One thing to bear in mind is that whilst you might receive dividend payments where applicable, you also will have to pay them to the broker if you choose to go short, however, as going short is currently outlawed on large proportions of the stock exchange, it is not something to be concerned with.
Most spread trading brokers allow you to place stop-losses (the spread betting and CFD trading company Capital Spreads offer a fixed risk account for instance), this means that you will not lose all of your money if it so happens that your judgement is wrong and the share value moves in the other direction. However, not all brokers do, and even if they do it might be set at such a level as to seriously damage you financially, make sure that you check where the stop loss level is, and keep it in mind.
Spread trading is a dangerous commodity and not for the inexperienced, buying in spread bets means that the FSA (Financial Services Authority) will believe that you are a professional and, as such, you will lose some of the protection that you may otherwise have received. Be careful when engaging in the trade of spread trading and make sure that you know the markets that you are playing with. When uses wisely trading on margin can help you magnify returns and maximise trading opportunities.
The biggest danger of trading spread bets is that you can lost an amount in excess of your deposited amount. Advantages include being able to take advantage of short-term market movements, the opportunity to hedge a shares portfolio, access to global markets and the ability to profit from markets that are falling in price. So, when they are good they are REALLY good, but when they are bad they they can rotten if you’re not careful with stops.