A: Spread betting providers make money in a variety of ways. Spread betting brokers make the most of their money from the spread; they typically add a small margin above the usual market spread, so a share priced at 100p to sell and 102p to buy might be 99p to sell and 103p to buy via a spread bet. For instance as I'm writing the spread around the underlying bid and offer of Vodafone is a total of 20 basis points (0.2 of 1 percent). The spread means that at any given time, the price that you can buy at is always higher than the price you can sell at. This also means that the provider makes a profit from the spread whether you win or lose.
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Your spread bet does not affect the share price of vodafone as it is a contract between yourself and the spread betting provider. So, if you go long by 10 pounds a penny the provider is effectively short 10 pounds. Bear in mind that there may be thousands of trades in vodafone throughout the day so the provider's overall position may be constantly changing. Ideally, for every trader placing a long position with a spread betting provider there is another trader placing a short bet. This means that one trader will win and one will lose, and the provider will end up simply making money from the spread. In practice, depending on the nature and overall size of the provider's 'book' they may also hedge their exposure independently - which could take the form of buying or selling shares on an exchange. However, the fact is that if a spread betting firm doesn't hedge your bet in the wider market, then they stand to win when you lose and lose when you win.
Also note that for a stock like vodafone there is plenty of liquidity but for others there may be very little so a provider may potentially offer a limited size in which to trade. Many illiquid stocks (in the open market) have a number of market makers that offer prices, but again, only in a certain size (normal market size - NMS). The normal rule of thumb would be that the provider is able to offer the equivalent as a spread bet so that that they can cover that bet fully (and not over-expose themselves).
And they also charge you financing on your open spread bets (currently about 5% a year) - this either takes the form of a daily financing charge or by adjusting the price of your bet. Of course they will also make money on the interest generated on unencumbered funds...and all these charges taken together do add up so it is imperative that you shop around for the best combination of spreads, margin and financing rates.
Perhaps the right question to ask is: How do spread betting providers NOT make money?
The December 2009 trading update from London Capital Group provided some interesting insights into their business model. The shares of LCG took a battering after the group posted a profit warning. This is interesting in that London Capital Group are becoming a sizable player in the spread betting industry operating both their own brands (ProSpreads and CapitalSpreads) as well as a number of major white-label partners including: Paddy Power Trader, TradeFair and SaxoSpreads.
Reading from the trading update, a number of interesting factors contributed to the profit warning that I think spreadbetters would find interesting:
1) Development of these white label partner sites is turning out to be costly.
2) Spread betters are winning more. Which of course is good news for us. This seems to imply that when the market is stable (i.e. relatively predictable), and with the markets in a general upward direction since March 2009 (to December 2009) it becomes easier for punters to come out on top. 'Less volatility means that people are more confident about sitting on their positions when the market goes the other way,' on analyst from the Financial Times was quoted as saying. Thus less people close out their losing positions, which is how spread betting providers make large portions of their monies.
For spread betting providers such as London Capital Group, the worst conditions appear to be slow-moving markets – as they encourage spread traders to hold a single spreadbet as opposed to jumping in and out with fresh bets. Low trading volume and having to split revenues with white-label partners can dent profits during calm markets. But volume and profits soar when volatility is high – as is the case at present...
With interest rates as low as they are we make very little money on client funds and on financing charges. In 2009 it is estimated that our revenue (LCG's) was impacted by up to £3.5m by the low interest rate environment. Interest rates are unlikely to increase for the foreseeable future and therefore LCG must make the majority of its income from client activity. It is fair to say that the last five weeks up to 26th May 10 have suited our business model but as is often stated we have no certainty of earnings - Siobhan Moynihan, Group Finance Director of LCG.
A: Technically, yes this is correct - when you take on a spread bet, you're taking a bet against the spread betting company as it acts as the counterparty to your trades. Remember that spread betting is just another vehicle with which to trade the financial markets, but it's a zero sum game: there's always someone on the other side of your trade. Spread betting providers hedge your position internally by matching opposing trades or by taking real positions in the markets (I am pretty sure that I have heard them go long in the market a few times when placing bets on the telephone) but they still have an inherent interest in you losing on your bet. This is because market makers not only make money on the spread and through commissions and perhaps financing over time, but they may make more money if you lose on your trade if they don't have an underlying hedge (and they won't run a hedge for small exposures).
We know that with short-term trading no wealth is created, it's just shifted around from you to them (or other traders). When using spread betting to open a position in any direction the 'trader' is theoretically betting against other 'traders', as the normal practice is that roughly as much short money as long money is going in so they make their money on the spread and the clients that are correct merely take the money off the clients that are wrong. However, for this setup to work the flow of business has to be so large as to make the market direction virtually academic to a provider's revenue income. Should there be some rather large discrepancy between the two groups either due to either a few clients having very large positions or the majority of clients are going in the same direction, the 'provider' will have to hedge itself so it does not go 'bankrupt' or make a substantial loss should the group with the overweight position 'win'.
Having said that, for spread betting providers to attract customers, it's in their interest to represent the underlying market as close as possible, otherwise they will be worse off overall and also open themselves to arbitrage opportunities. Quite obviously I still prefer spread betting to CFDs (with a CFD DMA position like those offered on IG Markets you are technically taking a position against another trader) because of the whole tax free benefit but it's important to note that they can't actually mess you about too much since prices mirror real underlying markets and because you'll just move on to another company as there is a lot of competition in this sector.
A: The bid-offer spreads for individual stocks are calculated as a percentage of the stock price.
The main factor affecting the percentage is the liquidity in the market. If there is a wide spread in the underlying market (exchange) where your spread betting provider may hedge your trade, this will be reflected in the spread that the bookie quotes.
For instance Capital Spreads quotes -:
UK Shares: 0.1% either side
US Shares: 0.1% either side
A: The spreads that the spread betting providers quote mirror the actual spreads available by the underlying market. In the case if LLOY stock for instance, IG Index charge 0.05p extra on the buy and sell side. So 54-55 will be 53.95-55.05. Sometimes these spreads will widen or tighten, this is all based on the volatility of the underlying asset. In a very volatile market, the price is much harder to predict and thereby the spreads are prone to be wider. But in stable markets like FTSE 100 stocks, the spreads are usually much tighter.
Hope that answers some of your questions but feel free to send me queries, comments or concerns at traderATfinancial-spread-betting.com or by filling in the form below :-)
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