As in stock market trading, two prices are quoted for
spread bets - a price at which you can buy and a price at which you can sell.
The difference between the buy price and sell price is referred to as the spread.
The spread betting company profits from this spread, and this allows spread
bets to be made without commissions, unlike stock market trading.
A Basic Stock Market Trade vs. a
Spread Bet
Here we'll cover a practical example to illustrate the pros and cons of this derivative market and the mechanics of placing a bet. First we'll take an example in the stock market, and then we'll look at an equivalent spread bet.
Here we'll cover a practical example to illustrate the pros and cons of this derivative market and the mechanics of placing a bet. First we'll take an example in the stock market, and then we'll look at an equivalent spread bet.
For our stock market trade, let's
assume a purchase of 1,000 shares of Vodafone (LSE:VOD)
at £193.00. The price goes up to £195.00 and the position is closed, capturing
a gross profit of £2,000, having made £2 per share
on 1,000 shares. Note here several important points. Without the use of margin,
this would have required a large capital outlay of £193k. Also, normally
commissions would be charged to enter and exit the stock market trade. Finally,
the profit may be subject to capital
gains tax and stamp duty
Now, let's look at a comparable
spread bet. Making a spread bet on Vodafone, we'll assume with the bid offer
spread you can buy the bet at £193.00. In making this spread bet, the next step
is to decide what amount to commit per "point", the variable that
reflects the price move. The value of a point can vary. In this case we will
assume that one point equals a one pence change up or down in the Vodaphone share price. We'll now assume a buy or "up
bet" is taken on Vodaphone at a value of £10 per point. The share price of
Vodaphone rises from £193.00 to £195.00 as in the stock market example. In this
case the bet captured 200 points, meaning a profit of 200 x £10, or £2,000.
While the gross profit of £2,000 is
the same in the two examples, the spread bet differs in that there are usually
no commissions incurred to open or close the bet and no stamp duty or capital gains tax due. In the U.K. and some other
European countries, the profit from spread betting is free from tax.
However, while spread bettors do not
pay commissions they do suffer a bid offer spread, which may be substantially
wider than the spread in other markets.
Keep in mind also that the bettor
has to overcome the spread just to break even on a trade. Generally, the more
popular the security traded, the tighter the spread, lowering the entry cost.
In addition to the absence of
commissions and taxes, the other major benefit of spread betting is that the
required capital outlay is dramatically lower.
In the stock market trade, a deposit
of as much as £193k may have been required to enter the trade. In spread
betting, the required deposit amount varies, but for the purpose of this
example we will assume a required 5% deposit. This would have meant that a much
smaller £9650 deposit was required to take on the same amount of market exposure as in the stock market trade.The use of leverage works both ways, of course, and herein lies the danger
of spread betting. While you can quickly make a large amount of money on a
relatively small deposit, you can lose it just as fast. If the price of
Vodaphone fell in the above example, the bettor may eventually have been asked
to increase the deposit or even have had the position closed out automatically.
In such a situation, stock market traders
have the advantage of being able to wait out a down move in the market, if they
still believe price is eventually heading higher.
