What is spread betting?
Spread betting is a special type of wager entered into between a customer and a bookmaker. Is spread betting profitable? Read on to find out in this exhaustive guide to spread betting.
In an ordinary bet, the gambler risks a ‘stake’ in return for a return based upon fixed odds which are agreed when the bet is placed. If specific conditions are met, such as the victory of a football team, the customer sees their stake returned, with a profit.
In contrast, spread bets are placed upon a prediction of whether a price will move up or down. Examples include the value or price of an asset such as an index or a share. The amount won or lost by the gambler will vary depending on how much the price has moved.
An example of a spread bet:A customer could wager ‘£1 per point increase in the FTSE 100’, with a starting index value of 6,700.
If the index rises to 6,800, the customer would win £100.
If the index falls to 6,600 the customer would owe £100 to the bookmaker.
This relatively new form of betting has given birth to a new bread of companies that allow people to bet on the financial markets using this betting system.
What are the Advantages of Spread Betting?
The websites of spread betting providers, which include CMC Markets, IG and CityIndex, make interesting claims on their websites. These may encourage investors to consider using spread betting as an alternative to ordinary investments. These claims include:
- Enjoy access to broad range of markets, including shares, indexes and foreign currencies.
- Spread betting profits are tax-free
- Trade like a professional on high tech trading platforms using live market data
Is Spread Betting Profitable?
Absolutely not. In fact, the vast majority of customers on spread betting sites actually lose money. This is a form of gambling, rather than investing.
Signing up for a spread betting service as an amateur is closer to joining a casino, than the stock market.
Read on to learn more about how spread betting works, and why we have reached this conclusion.
More Differences Between Spread Betting and Ordinary Betting
In spread betting, you do not gamble with a fixed stake. This means that the ‘downside’ of a spread bet is potentially unlimited. If we apply more extreme circumstances to the spread betting example above. At the stake level of £1 per point, the customer would lose £3,300 if the FTSE 100 fell to 3,500 as it did in 2008.
Spread betting companies allow customers to place ‘stop-loss limits’ which try to automatically close a bet if the loss exceeds a pre-determined level. In theory this should cap losses. However, in reality these do not work all of the time. Occasionally the underlying index or share price can slip quickly and skip past the exit price, which may result in the stop-loss failing to activate. Alternatively, it may execute but at the lower price (and hence a greater loss).
Another key difference is that very little cash is required to fund a large bet. When customers only need to pay a portion of their exposure in cash, this is known as ‘trading on margin’ or ‘using leverage’. The counterparty (in this case the bookmarker) is effectively lending you the remaining cash to create the full position. Therefore this will attract an interest charge if your bet remains open for more than a day.
For example; CMC Markets offers a ‘5% margin’ rate for bets on large UK companies. This means is that only 5% of the maximum loss needs to be deposited upfront by the customer.
This isn’t just about convenience for the customer. Leverage dramatically increases your profit or loss. Being able to use less cash to fund a large position, means that you will take large positions compared to zero leverage. Therefore, the outcomes will be larger relative to the cash invested.
A Comparison to Real Investing
As we explained in our article ‘What are Shares and Why do People Invest in Shares?‘, investors are entitled to dividends from ordinary shareholdings. However, you will not receive dividends from a spread betting company while you hold an upward bet on a share price. This is because you are placing a bet with a bookmaker rather than actually investing in a profitable asset.
If you trade via a stockbroker, you pay a transparent trading fee to buy or sell shares. When spread betting, you pay indirectly by trading at the ‘spread’. This means that the prices you ‘buy’ and ‘sell’ at are biased in the bookmaker’s favour (See ‘The House Edge’) below.
If you hold shares, you gain voting rights and the ability to attend an Annual General Meeting (AGM) of the company. If you bet on a company via spread betting, you do not gain such rights, as you do not legally own a share. Instead, you are a party to a contract with the bookmaker.
Due to the complex way in which spread bets are structured, you will actually be charged interest for holding a bet open longer than one working day. This is effectively a ‘charge for leverage’.
The Upside of Leverage
In the introduction, we explained that a spread bet requires only a small upfront deposit relative to the ‘size’ of the exposure. Let’s use an example to look at how this works in practice:
Leverage in actionThe share price of a company is £2.50. A spread betting company offers 5% margin on bets. A customer bets £1 for each pence increase in the share price.
In real life, to experience a £1 gain for every pence increase in a share price, you must own 100 shares. Therefore the theoretical investment that this bet replicates, is a £250 shareholding of 100 shares.
The maximum loss will occur if the share price became zero. In this instance, the customer would lose £250. (250 pence movements x £1 bet per point).
At 5% margin, the bookmaker would ask the customer to deposit 5% of the £250 exposure as a stake. This is just £12.50. Again, the customer has invested just £12.50 of their own cash, and now has the same price exposure as if they held £250 of shares.
If the share price subsequently increases by 5% to £2.63, the customer has won 12.5 pence movements at £1 per point, so £12.50.
This demonstrates the amplification of returns by leverage. Using only £12.50 of cash, the customer experienced a profit of £12.50 (a 100% return) on an underlying share price increase of only 5%.
The Downside of Leverage
Of course, leverage can also work against the customer. If the share price had fallen by 5% instead, the resulting £12.50 loss would have wiped out all of the customer’s deposit.
6/100 companies listed on the London Stock Exchange saw falls of 5%+ on the day this article was published. Any customers betting upwards on these companies at 5% margin would have seen their stake completely wiped out.
Bizarrely, a total loss is not even the worst case scenario. A unique drawback to leverage is that you stand to lose more than your deposit. If the shares had fallen by 10%, the customer would owe the bookmaker a further £12.50.
Leverage can lead to financial disaster. The two necessary ingredients are an extreme market movement and a large exposure. The Independent reported in 2015 that a teacher was trading £100 per 0.01 cent increase in the Euro against the Swiss Franc. After a dramatic change in policy by the Swiss Central Bank, the Euro plummeted and the teacher found himself owing £280,000 to IG, a spread betting company.
The House Edge – Spreads
You might be wondering – how does a spread betting company make a profit?
The chance of a share increasing or decreasing on a single day is approximately 50% each way, therefore given that punters can choose which direction to bet, how does the house have an edge on the bets you place?
The answer lies in the ‘spread’. The spread is the starting price at which your bet actually begins to make a profit.
In the example in the image, the real FTSE 100 level was 7.485.43. To bet upwards, you must agree to a starting point of 7,485.93. This means you will only begin to profit if the index moves 0.5 in your direction. If betting downward, you must agree to a starting point of 7,484.93.
This subtle shift of the goalposts tilts the odds towards the provider. Now, if the price moves against you or stays the same, the provider will win. This is the digital equivalent of the provider slightly weighting a coin in their favour after you have backed a heads or tails.
The wider the spread between the buy and sell price, the more margin a bookmaker is scraping from bets. The spread on the FTSE 100 above is very narrow, as spread betting providers compete fiercely on spreads. However – whilst the spread looks small, the effect is amplified by 20x due to the leverage. As we explain in our demonstration later, the spread will cost a minimum of £50 for each £10,000 trade, so this is not an insignificant expense.
The House Edge – Extreme Volatility
The spread is not actually the killer factor working against customers on the spread betting platforms. The real killer is volatility.
You may recall from our article on risk and diversification that volatility is harmful to returns. Despite having a positive ‘average return’, a series of sharp gains and losses will destroy a portfolio’s value. This table featured in that article:
|Investment performance||Mean average return per year||Actual portfolio value after ten years|
|3% then 7% alternating||5%||£1,626|
|-5% then 15% alternating||5%||£1,556|
|-15% then 25% alternating.||5%||£1,354|
|-25% then 40% alternating||5%||£904|
|-50% then 60% alternating||5%||£328|
The final row is an extreme example which is unlikely to occur in an ordinary trading portfolio of shares. However, it’s actually representative of what can occur on spread betting accounts.
Demonstration of volatility on a real spread betting platformUsing a demo account offered by CMC Markets, we can perform an example trade to demonstrate the dangers. The demo account begins with a fictional balance of £10,000.
We placed a bet of £34 per hundredth of a cent increase in the value of the Euro against Pound Sterling. This bet used the full £10,000 deposit. It represents a massive underlying position of £300,000 worth of Euros.
Within one second, our loss was £50. This is the effect of the spread. Given that the goal post has been moved slightly above the current value, we are instantly in a loss-making position.
It didn’t improve from there. At the end of the first minute, the position was a loss of £353.60. We generated a 3.5% loss in just 60 seconds. By the following morning, the demo account was showing a £1,097 loss.
The House Edge – The Gambler’s Ruin
Another factor stacked against a customer has finite funds, whereas the provider’s resources are virtually unlimited.
Gamblers ruin is an observable concept that:
- If two players play a game with equal odds of winning
- Where one player has finite money and the other has infinite money
- For an unlimited number of games
- The player with infinite funds will win 100% of the time.
If a customer makes a large gain, the provider will still be able to continue to bet against the player in the future, and indeed will encourage the customer to continue to do so. Given that the wins and losses are occurring randomly if the customer plays long enough, a losing streak will eventually emerge which will bankrupt the player.
This effect is extremely powerful in spread betting. Because of leverage, even a small losing streak will bankrupt a player. Therefore, in combination with the other advantages that the House enjoys, players can run out of funds extremely quickly.
The Shocking Statistics
This brings us to the overall reason why Financial Expert does not recommend spread betting.
Approximately 80% of spread betting accounts lose money.You would do far better in a savings account, although you deserve better!
If that statistic doesn’t sound credible, just read a sample of the warning messages found on the websites of the top three UK providers:
This is why we are so confident in answering the question of ‘Is spread betting profitable?’ with a resounding ‘No’.
Overall, spread betting clients, like casino and bookmaker clients, lose money. As a result, HMRC treats spread betting profits just like gambling profits. They’re tax-free.
You begin to get a picture of how rare and fleeting spread betting profits are when even the tax authority doesn’t feel it would be fair to tax them.
The Risky (Risk-free!) Trap
Spreadbetting companies always offer demo accounts for prospective customers. Demo accounts are filled with play money and customers can use this to place bets and see what happens. This is a sensible product to have, but also a very crafty one.
It is sensible to allow customers to familiarise themselves with a trading platform, and a new betting system. This will reduce the number of painful ‘newbie errors’ made with real cash.
But this is also a trap. A small proportion of demo customers wondering ‘is spread betting profitable?’ will experience a remarkable series of events which may tempt them into danger.
With pretend money, clients will happily place large bets, and due to the ‘up or down’ nature of the bets, just under half of these will win. Half of those winners will also win the next bet, and so on. With nothing but good luck behind them, 6% of customers will win their first four bets and 3% will win five. By this point, their demo accounts may have doubled or tripled in value. Confidence will start to take hold in even the most sceptical of brains.
‘I must be good at this’, they may ponder. ‘Trading the financial markets is a skill-based affair and I seem to have the skill to consistently make a profit’.
Clients will feel a pang of regret that the winnings are fictitious as they hadn’t used real cash to place the trades. At this stage, customers are only one decision away from depositing real money in the expectation that they can repeat their winning streak.
They, like 80% of other new sign-ups, will be setting themselves up for disaster.
Is Spread Betting Profitable? It is for the Spread Betting Companies!
From which perspective is spread betting profitable? The provider’s perspective! Unlike a stockbroker, a spread betting company will only generate income if their clients lose.
In 2017, CMC Markets PLC generated net operating income (i.e. fees and winnings) of £160.8m. After salaries and other costs, the firm posted a profit before tax of £48.5m. An incredible profit margin of 30%.
For the same period, IG Group saw net operating income of £491m and the parent of CityIndex generated $308m.
Close to a billion dollars of net operating income, demonstrates the vast scale on which these ‘trading platforms’ beat the investors they claim to support.
Learning Points Summary – An Investor’s Guide to Spread Betting – Is Spread Betting Profitable?
- The factual answer to ‘Is spread betting profitable?’ is no.
- A spread bet is a directional bet, where the gambler wagers a stake per unit of price movement in any direction.
- Spread betting is not a sensible alternative to ordinary investing. While gains and losses can be made from price movements, however, this is where the similarities end.
- As a spread better, you will receive no dividends and will need to pay interest if you hold buy positions longer than 24 hours.
- Share and bond investments have a positive expected return, whereas 80% of spread betting accounts lose money.
- Spread betting providers only generate a net income if their customers lose. The top three providers reported over £1bn in net income in 2017.
- Spread betting companies have three edges over their customers:
- 1. The price of the bet on is skewed in favour of the provider. This is inherent in the ‘spread’ between the up and down starting prices of bets.
- 2. The high ‘leverage’ inherent in the size of the positions will result in highly volatile returns, which will erode the value of a portfolio over time, even if the average return is positive.
- 3. Even a short losing streak has the capability to wipe out a customer’s deposit. If a customer continues to place bets over the long term, it is only a matter of time before their capital is eliminated. This is why the loss rate is so high.
We hope this article has answered the question of ‘Is spread betting profitable?’ Like any other form of gambling, if you only play with money you can afford to lose, spread betting could be fun. However, we recommend you save your pennies and invest them for a brighter future!