Turning a small percentage price move into a big percentage return is called “gearing” or “leverage.” Spread bets are leveraged products. You get leverage when you only have to put down a small amount of money to control a much bigger position.
Leverage is in essence trading with someone else’s money, thus raising the stakes. You can have a position in the market 10 times or 50 times greater (that is leverage at a ratio of 10 is to 1 or 50 is to 1). The difference is if you look at the effect that has on your profit and loss, it basically amplifies 10 times or 50 times.
All spreadbets are by their very nature leveraged, meaning that you are only required to initially deposit a small fraction of the total exposure to place a
trade (also known as margin trading).
The normal initial margin requirement for UK shares spread bets varies between 5% and 10% for the large and mid-cap stocks of the FTSE 350. Smaller stocks including those listed on Aim are generally more volatile and less liquid, which is why they often need a deposit of 25% or even 50%.
Take the example of our BP trade. Say the share price is 500p and you took a spread bet position at £10-a-point, which is equivalent to buying £5000-worth of shares.
Whereas buying £5000-worth of actual shares would involve stumping up £5000, a spread betting company might only ask you to deposit, say, £500 in order to fund the same value position with them.
Let’s assume BP’s share price then rises 11 per cent, increasing the total value of your position from £5000 to £5550. So, you’ve made a profit of £550. However, because you only put down a deposit of £500, your return is £550/£500 = 110 per cent. Not bad going, considering the share price only changed by 11 per cent!
Naturally, leverage cuts both ways. If you get it wrong, your position can get wiped out very quickly. If a share spread bet is traded on 10% margin it allows the investor to take out an exposure equivalent to ten times as many shares as they could were they to invest directly in the underlying. This means that a 10 per cent drop in BP’s share price would eat up your entire £500. To keep your position open, it would be necessary to top up your account with fresh funds.
And that’s why leverage can be dangerous. So when you utilise leverage in a scenario where the market becomes very volatile or you use leverage to average against the losing position, you run the risk of taking on much higher levels of risk than you would like to. It simply amplifies the ability to make money or lose money. As a result, it is essential to use leverage carefully. This means not taking on positions you can’t easily afford.
Profit from falls as well as rises
What if you think BP’s share price – or any other asset – is going to fall rather than rise?
With spread betting, it is just as easy to make money from something going down as it is from it going up. You simply reverse the steps you’d do for a buy trade, thereby creating a ‘short’ position.
Perhaps the FTSE 100 has rallied too far, too fast in your opinion. It currently trades at 4500 but you envisage it falling to 4000 over the next few weeks. So, you log in to your spread-betting account and “sell” the FTSE 100 – even though you don’t already have an existing ‘buy’ trade open. As a result, you have short-sold the FTSE 100.
Let’s say you are right about the FTSE, which drops to 4000 in a fortnight. To close your short position, you simply place a buy trade, which cancels out your sell trade. You thereby crystallise a profit of 500 points multiplied by the size of your trade. So, if you had placed a spread bet of £5 a point, your profit would have been £2500.
Note: Be careful and don’t whatever you do make a big bet and go off and make a cup of tea and toast..it could be a very expensive treat when you have forgotten (STUPIDLY) to put a stop-loss on 😉