Financial spread betting explained

Financial spread betting is essentially a form of derivative trading. Like any other derivative, the value of the position is based on the value of another underlying security or commodity. What this means is that when you place a trade with your broker, you are not buying or selling the actual share, index or commodity, all you are doing is speculating on the future price of that security.

In other words, spreadbetting allows traders to trade the markets without ever really owning the underlying instrument. So a trader can back her opinion on the direction of the price of any market, whether it is major currencies, commodities, stock market indices or individual companies' shares without ever owning them.

Like a Contract for Difference (CFD), a spread bet can be thought of as an agreement between a trader (you) and the broker to exchange the difference between the opening and closing value of the bet at a future date. Depending on the particular security that you are trading (and the bet type that you are using), the future date can either be fixed or open ended. Your profit or loss is calculated as the difference between the opening price and closing price of the bet, multiplied your stake.

While financial spreadbetting is essentially a short-term trading tool, long term buy-and-hold investors can also benefit from using spread bets as hedging tools to protect the value of their long-term holdings.

One important feature of spread betting is that you trade using substantial margin (or leverage). What this means is that you are essentially trading with borrowed money as you are only required to deposit a fraction of the value of the bet you place. Consequently, any fluctuations in the price of the underlying security can quickly result in big profits or losses. In particular, it is worth highlighting that as a result of the margin, your losses can exceed your initial deposit, in which case, you would have to make further payments to cover the extra losses.

Viewed in this way, it is clear that leverage is a two-edged sword, and the flip side is that your spreadbetting profits can grow very rapidly indeed (if the bets go your way), resulting in gains that could be several multiples of your initial deposit. Needless to say, spread betting is a high-risk, high reward form of trading.

What are the advantages and disadvantages of financial spread betting?