The Downsides of Spread Betting in the UK - dummies

By David Stevenson

With spread betting (is a specific type of gambling legal in the UK in which you win not by picking a winner or loser, per se, but by correctly identifying whether the actual outcome is higher or lower than the stated range) your losses are theoretically unlimited. Therefore, using risk-control measures is certainly worthwhile. You pay a little extra for caps on your losses, but you need to do so to control your downside.

Stopping your losses

A stop loss is your automatic get-out plan if a trade doesn’t work out. It immediately closes your position when the price moves against you by a certain amount. By closing the position at a loss, at least you’re saved from incurring even bigger losses.

Imagine that you’re trading the value of an index such as the FTSE. The FTSE can be volatile, sometimes moving hundreds of points within the space of a couple of hours. You think that the FTSE is going to rise, and so you buy when the index is 5,100 at £10 a point.

Many spread-betting systems now automatically put on automatic stop losses based on one of two key variables: the minimum margin requirement or how much money on account you have:

  • Scenario 1 – minimum margin requirement: The minimum margin is 30 and the maximum computer-generated stop loss is 150 (the maximum in margin it holds for a £1 position). So the minimum margin required is 30 x 10 = £300, and because you’re buying the FTSE, the stop loss is placed 24 points below your entry price (80 per cent of the margin is typical).

  • Scenario 2 – amount on account: You put £100,000 in your account and run the exact same trade. In this case many spread-betting platforms take the maximum amount of margin required (150 of index points) and place the automatic stop loss 120 points below your entry price (again, the typical 80 per cent of the margin). If the market falls 120 points, your trade is stopped automatically and on this occasion you’ve lost £1,200.

One especially useful feature in spread betting is a trailing stop, a special type of stop loss order in which, instead of setting a specific price as the trigger that closes your position, you set a percentage level. This percentage always remains the same but follows (or trails) the price as the price moves. As long as the price doesn’t fall below the specified percentage, the stop order doesn’t get triggered.

Setting a trailing stop helps you to secure your gains as the market moves in your favour, giving you added flexibility because trailing stops automatically track your profitable positions so that you don’t have to monitor your position continuously and move your stop manually.

For example, say that you set your trailing stop to 15 per cent. For a stock that is selling for £100, the stop would be triggered if the price fell to £85, but if the stock price rises to £110, the new trigger is still 15 per cent below that price; now the sell order would be triggered if the price fell to £93.50.

You need to set the distance you want your trailing stop away. If the market then moves in your favour, the trailing stop moves in. Always ask yourself the following questions:

  • How far can a price move against me before I’d change my view about the outlook for the asset I’m trading?

  • How much can I sensibly afford to lose on this trade?

Move your stop loss as events change, but also be cautious about moving your stop further away when things start going against you!

Hedging your portfolio using spread bets

Assume for a moment that you’re worried by a major downwards move in the big equity markets, following a big scare of some sort. Although you can dump all your shares and wait in the hope you’ll be able to buy them back at cheaper prices, this strategy is pretty risky (what with all those trading costs, plus the fact that market timing is notoriously difficult and knowing its exact top or bottom is never easy).

Another alternative is to use spread bets to hedge your portfolio. Imagine that you hold £20,000 of FTSE 100 shares and the market falls from 6,500 to 6,200 points. The losses on your portfolio would be around 4.6 per cent (£920). However, if you’d placed a down bet on the index using a spread bet at £3 per point you’d recoup a profit of around £900 (£3 x 300 points), which almost offsets the losses within the main part of your portfolio.

To work out how much you need to bet to hedge your portfolio, take the value of your holdings (£20,000 in this instance) and divide by the level of the index at the time of the bet (6,500 points). The result is approximately £3 in this case. The hedge achieved isn’t exact – you still lose a little bit – but that’s better than losing £920.