Different Applications of Spread Trading

Spread trading can be used in many different ways.

Speculation

Speculation is the most obvious motive for financial spread trading, and the reason why probably 95% of bets are placed.

Financial spread trading offers several key attractions to the speculator -:

  • It provides speed and ease of use.
  • It provides leverage (because large positions can be taken without the punter having to put cash up front to cover the whole exposure).
  • Any profits are not liable to capital gains tax.

Anyone with a financial spread betting account at a spread bookmaker can make a wide range of bets just by picking up the phone, sending an email or trading directly over the Internet.

This wide range includes:

  • individual share prices;
  • International stock market indices;
  • Certain US, Australian and European share prices;
  • Government bond futures;
  • Interest rate futures;
  • Foreign exchange rates;
  • Commodity futures;
  • Equity and stock index options. A trader can close a bet any time before its expiry just as easily as he or she opened it.

A spread trade also provides greater leverage than do many trades on conventional markets.

Anyone buying shares for instance normally has to pay the entire purchase cost within three days of placing the order.

By contrast, spread trades can be made “on margin”. Someone making an “up-bet” on a share price will be asked to make an initial deposit as a percentage of the entire value of the underlying exposure of the bet.

The initial deposit required is likely to be only some 10% or 15% of the underlying exposure.

If circumstances where the trader has access to a credit account with the bookmaker concerned, then an initial deposit may not even be required up front.

Instead, he or she would only have to send cash if losses on the trade reached a certain level. These payments are known as “margin calls”.

Profits made on trading in shares, unit trusts, futures or options in the conventional markets are subject to capital gains tax (CGT).

Under current law, profits made on financial spread trading – like profits made on other types of casual betting – are not liable to income tax.

Hedging

Although most people who use financial spread betting companies will only use the facilities to speculate with, they can also be used for hedging purposes.

Many private investors have exposures in their normal finances that make them feel uncomfortable at times.

  • They might have a big equity portfolio at a time when they felt the stock market was at risk. If so, they might decide against selling a large chunk of shares, because it would trigger capital gains tax and incur dealing commissions.  Also, if their diagnosis happened to be wrong, and share prices went up further, they would have got themselves stranded in cash.
  • They might find themselves with no exposure to equities at a time when they felt the stock markets could take off. They might not have liquid resources handy to commit to buying stock, or they might feel hesitant about committing spare cash.
  • Their exposure might be to an exchange rate.

Spread trading can offer two types of hedging -:

The first is when an underlying exposure in conventional markets is offset by an equal exposure in the opposite direction through a spread trade. The second is geared hedging, in which a spread bet is used to protect a portion of the underlying exposure from big market movements.

  • A private investor preparing to commit a few thousand dollars to the stock market at the start of the new financial year could make an “up-bet” on the index a few weeks before. This would prevent him getting caught by a bounce in share prices before the money could be deployed in early July.
  • A private investor with a large share portfolio could hedge this against a market correction by making a “down-bet” on an out-of-the-money stock index put option. This would expire worthless if the equity market carried on up during the option’s lifetime, but would jump in value if the market fell sharply. Profits on the option could partly, wholly or even more than offset the drop in the value of the investor’s portfolio.

Let’s suppose that you have a large holding of UK stocks or a particular share. You are somewhat concerned about the global economy and the financial crisis and believe that you are likely to suffer short-term declines on your investment because of the market jitters. As opposed to selling up or riding out the storm, you could hedge your sharesholding. Let’s say you’ve £60,000 of Next shares. To hedge against this risk, you could take out a short position also worth £60,000 via a spread bet. If you do so, you have effectively neutralised your position. For every £1 that your Next shares went down, your Vodafone short position would go up in value by £1. The net outcome is thus zero and your wealth is protected.

Sometimes it is useful to mitigate risk by hedging particularly when spread betting as the leverage can be truly overwhelming. However, before considering hedging by taking an index position make sure you have a diversified selection of shares or you run the risk of being long on a particular share and short on the wider market. Just imagine your stock falling while the wider market is rising; this could lead to double-ended losses since you could end up with losses on both trades. This risk is reduced when you are holding a reasonable number of shares in different industries.

As such, as well as protecting individual positions from market declines, spread betting can also be utilised to hedge a whole portfolio. If you had a number of shares that were mainly made up of FTSE 100 and FTSE 250 constituents, for example, you could establish a position in the opposite direction.

Decide the extent of the hedge you want to partake. If your market exposure is £100,000 and you want roughly a 50% hedge, then you would look to take a down bet on the Footsie (or another index) for £50,000 of representative exposure. If the FTSE level is 6808, that would be:

50,000/6800 = 7.35

As such to put in an approximate 50% hedge, you would open a short spreadbet position at £7.50 per point

Arbitrage

With various financial bookmakers quoting prices, opportunities arise from time to time for arbitraging between them.

Essentially what “arbs” do is make a risk-free profit at the expense of the bookmaking industry. For that reason, bookmakers are not fond of arbitrageurs.

A spread trading arbitrage consists of making an up-bet with one bookmaker, and a down-bet with another – the gap in between is the arb’s profit.

EXAMPLE OF AN “ARB”

  • Bookmaker X is quoting a spread of 247-252 for the closing price of Blue Sky Mines on its first day of trading on the stock market.
  • Bookmaker Y however is more cautious about the price Blue Sky Mines will fetch, and is quoting a spread of 225-230.
  • Arnold the Arb grabs his phone and makes a $50-a-point “up-bet” with Y from 230, and a $50-a-point “down-bet” with X from 247.

Wherever the Blue Sky market spread moves in the days to come, Arnold is guaranteed a profit of $850 provided he waits until the trade expires at the close of the first day of official trading.

This figure is the 17-point gap between 230 and 247, times Arnold’s stake of $50-a-point.

In practice, arbitrage opportunities are relatively rare nowadays in financial spread betting.

Most bets involve an underlying financial market and so all the licensed financial bookmakers will try to make sure that their spreads reflect prices in that underlying market. Their spreads are therefore likely to be very similar, if not identical.

Most arbitrage possibilities open up on spread bets which are not based on an underlying market price, or that are based on an underlying market that is not open at the time. Examples of this include “grey-market” share bets, and out-of-hours bets on the international financial indices.

In both cases, bookmakers have to use their own judgment about what the underlying market price will be when the market opens – and these judgments sometimes differ. On the other hand, bookmakers tend to watch each other’s spreads carefully and when a gap does open up, they usually try to close it as quickly as possible.

That means that the “arb” has to have an eagle eye, and be very fleet-footed. The other anti-arbitrage action that bookmakers may take is to limit the size of bets that they allow known “arbs” to make.

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