Friday, 8 October 2010
Financial spread betting: not as confusing as you thought
The financial spread betting market may at first seem dauntingly complex, but it has a number of advantages for investors who want to access financial markets in a cost effective way. Don’t be put off by the jargon you read about in the newspapers: financial spread betting is easier than it sounds.
Before opening a spread betting account, it is important you understand both the risks and the rewards. First and foremost, in the UK spread betting is tax free, with no capital gains tax or stamp duty to worry about.
Not only that, spread betting lets you take advantage of falling prices as well as rising prices. Traditionally, share traders would ‘go to cash’ and stay out of the stock market when it was falling. They had no other option. More likely than not, they would lose money if they stayed invested. Spread betting allows you to take a ‘short’ position, meaning you would make money if the price goes down.
For example, the problems being experienced by BP are bad news for investors who hold BP stock, but when the Deepwater Horizon rig blew, a canny trader with a spread betting account might have decided to go short on BP by opening a sell trade, and profiting from the fall in BP’s share price.
There are other advantages to financial spread betting: because you are not buying a ‘physical’ asset you don’t have to worry about custody fees. Back in the day, when someone bought a share, they would also have received a share certificate, their title of ownership of that share. Today, banks and brokers still have to hold those shares for investing clients, but they charge investors a small fee for the service. Luckily for clients of spread betting companies, because they are not trading physical shares, there is no cost of custody. You are trading an instrument that follows the price of an asset in the market, but you don’t have to pay a bank to look after it for you.
While we are on the subject of costs, most spread betting companies do not charge commissions for trades. If you buy or sell physical shares with a stock broker, you will find you have to pay transaction fees on every trade you make. This is not a problem for someone who trades once or twice a year, but if you are planning to trade several times a month, the fees quickly rack up.
But there’s more. Spread betting companies now offer investors access to a wide range of financial markets, not just shares. Right now, it is the most cost effective way to deal in foreign exchange or commodities markets, or take advantage of price changes in international money markets. Foreign exchange or FX is arguably the largest financial market on the planet. It has no exchange that opens or closes, so as a trader you are using the prices that banks and other FX traders are using to buy and sell currencies around the clock. One of the best things about the foreign exchange market, however, is that there is always going to be a currency going up and another going down, regardless of what is happening in other financial markets like equities. Some traders in the spread betting market just focus on trading currencies, and if this is something that interests you, then spread betting is a great way to access these markets as a private individual.
Similarly, commodities markets let you trade prices in gold and oil, two of the most commonly followed commodities, as well as precious metals like silver and platinum, base metals like copper, energy markets, and agricultural products like wheat and frozen orange juice.
By opening a spread betting account you can follow all these markets on one screen using just a single spread betting company to get all your prices and news. You don’t have the hassle of switching between accounts when you want to move from your share trades to your foreign currency trades. In addition, by opening a spread betting account, you are trading all these markets in sterling. You are not worrying about any currency risk you might be taking on by buying a share listed on a foreign market.
Spread betting also lets you trade on margin. This means the spread betting company lends you the value of a proportion of your trade. You only need commit the margin rate – usually between 2% and 10% depending on the market you want to trade. Your money can go further while you still take the full amount of gains or losses from the trade.
Many spread betting companies also offer contracts for difference or CFDs. These are very similar to spread bets in the way they work, but there are some differences to bear in mind if you are UK resident. CFDs are used as an alternative to spread betting if you are living outside the UK or Ireland, but some traders like to use them in the UK because of the way they are treated for tax.
CFDs and spread bets work slightly differently: with spread bets you decide the amount of money you want to stake on each point the market moves. For example, you might want to bet £1 on each point the FTSE 100 moves. With CFDs, while you can still trade on margin, you buy and sell a CFD like a share, benefiting from the change in price. Just be aware that, while you only need put up the margin, and you are pocketing the gains from the full value of the trade, you are also responsible for the full loss.
The other major difference is tax. In the UK, CFDs are subject to capital gains tax. This means you can usually off-set losses sustained in your CFD trading in your overall tax calculation. CFDs are exempt from stamp duty, but you will usually be charged some form of commission by your CFD broker.
If you are interested in more frequent trading, or exploring new markets like commodities and currencies, or taking advantage of falling prices (trading off bad news for example), then spread betting and CFDs could be for you. Just remember that it is easy to lose more than your initial margin deposit if the market you are trading does not behave in the way you expect!