To compare spread betting to investing is a good way to highlight the benefits and disadvantages of spread betting financial markets. This article is meant for those who need a basic introduction to spread betting rather than spread betting explained in detail, or advanced spread trading strategies. For an introduction of how spread betting compares to investing and how it can complement investing this is the place.
To compare spread betting to investing is a broad topic. For simplicity, here, we have narrowed down a comparison to a few points to help. It is fair to say that a big difference between spread betting and investing is that spread betting is more complicated. Something that will become obvious when ‘reading on’. If learning learn how to spread bet then be patient with learning the arts of spread betting. It might be more involved than simple investment strategies but also more rewarding.
Why invest or spread bet?
It comes down to returns. The purpose of investing is to generate returns on money invested that are higher than the risk free returns available from a savings account or government bonds etc. A long dated government bond might get you an interested rate of something like 4.5%. To invest is to expect higher returns. Higher returns normally go hand in hand with some extra risk
What returns can you expect from investing compared to spread betting
Both can produce very good returns. The return on spread betting compared to investing depends on what spread betting techniques are being used.
Investing strategies normally have a time frame of weeks to years, for example, Ppension funds think very long term. Most retail investors who invest do so for the long term. A common strategy is to buy and hold shares in well known companies with solid competitive advantages in their market. Cash generative and with low debt they produce steady returns and good dividends over the long term. A reliable strategy , but a little boring possibly.
Spread betting involves placing trades over a shorter time scale. A spread bet might be closed after a day, a week, or for a few months. Spread betting on financial markets involves placing up or down bets on various markets, whether it is a daily market, or derivative markets where the underlying asset is a contract that finishes in intervals of months. An investment strategy may involve reviewing the holdings once a year. If a sector is tipped to outperform and another under perform the investor may want to balance their portfolio for future growth.
To compare the risk of spread betting to investing depends on what type of strategy is being used and over what time horizon.
Compared to investing spread betting is more risky than investing. Especially if you compare spread betting to a buy and hold investment strategy like the one mentioned before.
Why is spread betting risky?
Let’s look at an investing example first. You have 100 shares in Vodafone priced at £1.50 that has a value of £150. If the share price drops by 10p the value of your holding is now £140. If you decided to sell Vodafone you’d lose £10. Compare to spread betting this loss is smaller. Here’s why.
Spread betting is a leveraged product. Imagine that a spread trade was opened on Vodafone as part of some spread trading strategy. For each 1p movement in the share price the spread trader can bet an amount per 1p movement in the share price. Let’s say the trader chooses £10 per point (a point is the same as 1p in this example). Every 1p movement in the share price increases or decreases the value of the trade by £10.
In this case the share price drops by 10p. That’s 10 times £10. If the trader closes the trade the trading capital will have dropped by £100. That loss is 10 times more compared to the investing example. Ouch!
In addition spread betting can be done using a credit account. Potential loses can exceed the amount of money in the account. If the trader closes a trade resulting in a loss bigger than the trading capital the spread betting company will come knocking. This is called a ‘margin call’.
With this extra risk comes the potential for much higher returns. Imagine a trading strategy that aims to produce 10 points profit per day. The trader is trading at £10 per point. The profit would be £100 per day. If the trader trades £100 per point that’s £1000 per day.
Risk control with investing strategies focuses on doing thorough research on the underlying assets, be it shares in a company or property, and choosing the best time to enter the market. In addition online brokers and traditional brokers allow investors to set limits on the amount of money they are prepared to lose, otherwise known as a stop loss.
The concept of risk control with spread betting involves using reliable trading techniques. Stop loss orders would be used to control the amount of loses per trade. A good spread betting strategy aims to produce more winning trades than loosing trades. Winning trades would be allowed to run to maximise profits and loosing trades would be ‘stopped out’ to reduce loses.
How much capital is need for spread betting compared to investing
To achieve similar or larger returns than investing using spread betting much less capital is needed. This is due to leveraged nature of spread betting and the availability of credit accounts. With spread betting only a small percentage of the over all value of the trade is required to open a position. This is called the margin.
The amount of capital needed to open a trade depends on the spread betting companies margin rules. The margin requirement is the cash amount needed to open a position. It is sometimes called the deposit factor, initial margin or the Notional Trading Requirement (NTR). Each trade has a margin requirement to cover the potential loses on the trade.
A typical margin requirement for a trade would be between 5% to 25% of the underlying value of the deal. If the underlying asset that is being traded is non volatile and liquid like FTSE 100 shares the margin requirement could be as low as 5%. Imagine the Vodafone trade and £10 per point. The price is 10p higher giving a current value of £100. The amount of money needed in the spread betting account to maintain this trade is just £5. The value of each trade changes in real time as share prices increase and decrease, so this maintenance margin as it’s called changes accordingly.
Decision making for spread betting compared to investing
There are many tools in the traders tool kit available to help predict the direction of movement in asset prices. To decide whether or not to enter the trade the trader can rely on fundamental or technical analysis. To cut a long story short fundamental analysis involves looking at economic factors both on a large and small scale to investigate how this influences the market sectors. Within a market sector fundamental techniques use indicators of performance for individual companies.
Technical analysis involves analysing statistics produced by market activity. The aim of using technical analysis is not to work out the intrinsic value of the asset but to investigate patterns in the asset value. Technical analysis typically involves charting techniques such as looking at patterns to predict the future movement and extent of movement in the underlying asset.
Investing and spread betting will often involve a mixture of both techniques. Investing strategies tend to use fundamental analysis more, especially with a buy and hold strategy. Spread trading strategies will make more use of technical analysis. Day traders using spread betting only use charts to decide how to trade. Longer term trades will use some fundamental analysis because these factors play a bigger part in driving asset values up or down.
How can spread betting complement investing?
For individuals who already have an investment portfolio spread betting can be used as a means of spicing up returns. A percentage of the trading capital would be used for speculation; betting that asset values will go up or down.
Spread betting is unique in that it is possible to make profits if asset prices go up or down. In simplistic terms investing only produces profits if asset prices go up.
Let’s say an investor has a portfolio worth £100,000. If there is a shock to the market and asset prices drop the investor could sell some or all of the portfolio. This might not be a good idea. There could be negative tax implications. Also it locks in a loss and would cost money to buy back the same or similar assets.
Rather than selling another option is to hedge the portfolio against loses. This is something that fund managers do; not to say it’s particularly difficult. Spread betting is one way to hedge a portfolio against loses.
Using the Vodafone example, let’s say the Vodafone shares are part of a much large portfolio of shares in FTSE 100 companies. The investor could open a down or sell spread bet on the value of the FTSE index as a whole. As the FTSE 100 falls the sell spread trade would increase in value which would reduce the loss on the buy and hold investments. For retail investors there are alternatives to spread betting for hedging the value of a portfolio. These include contracts for difference or CFDs, and options contracts.
To round up the comparison of spread betting to investing lets look as some important points.
- longer term
- smaller returns if using a buy and hold investment strategy, although investing is a very broad topic this this might not always be the case
- lower risk – depending on the style of investing
- a straight forward relationship between risk and return
- Shorter term; the majority of trades are closed after a week or so
- Potentially higher returns using a good spread trading strategy
- Higher risk, although disciplined trading techniques makes this debatable
- Returns are leveraged. There is a multiplying effect on profits and loses
- More versatile;
- The ability to trade markets otherwise not accessible to retail investors; Asian market, metals, commodities, house prices you name it
- the ability to make profitable trades whether the market is going up or down or in trending or trading markets. There is truth in the saying the ‘trend is your friend’. Momentum trading strategies rely on trending markets
- Tax advantages
Spread betting brings a lot to the table. The ability to make larger returns from smaller stakes, albeit, with extra risks. Spread betting should not be seen as being more exciting than investing because the returns are greater. Successful spread trading techniques involve repeating the same techniques time after time to produce reliable profits. A good dollop of self discipline is required in the process. Although, that’s not to say the thought of financial freedom using spread trading isn’t exciting. Spread betting can also complement investing styles or be used for fun. Like a trip to Vagas is fun!