In the financial world, leverage refers to the use of borrowed money to put into investment products such as property, shares, artwork, property trusts or managed funds. One of the most important advantage about spread betting is that it allows leverage of your trading capital. Using leverage (also called gearing) refers to the ability to open a large market exposure using a relatively small capital outlay. In effect trading spreadbets is similar to taking a margin loan because when you trade a spread bet you are only paying a small percentage of the total value of your market exposure in the form of a margin payment. There are obvious risks attached to such an activity, but it does allow traders to open multiple trades or larger positions from a smaller capital base.
Leverage is sometimes called gearing and means that whatever the total value of your trade, you would only have to put up a small percentage of that value as margin (like a deposit). Leverage attracts many spreadbetters – allowing them to get a bigger market exposure and consequently bigger potential profits or losses with less need to deposit big amounts upfront.
Leverage can be very good if things move in your predicted direction – particularly so as you don’t have to find sufficient money to cover all of your trading positions – but it can also be bad since if you get it wrong losses can be substantial.
To open a spreadbet you will need to make a deposit at your spread betting company and this amount is commonly known as margin. The margin percentage gives you an idea of how much money need to be on account before you are able to open a bet. Individual stocks may require a margin rate of 10% so with just £100 in your account, you might be able to open a bet equivalent to holding £1000 worth of shares
Example: STAN stock is at 1420p is at the moment – I could just buy shares as I reckon it will get back to 1650p at some stage this year then sell getting my nice 16% return or I could use the same money with a stop at 710p and make twice as much (or lose twice as much) ensuring that STAN will never be back at 710p and lose the lot.
Find that hard to understand? Okay, let’s explain leverage with a practical example. If you buy £10,000 worth of stock from a stock broker you have to deposit £10,000 in your stock brokerage account. However, a spread betting provider may permit you to trade the equivalent £10,000 with just £1000 or less deposited in your spread betting account as all spread bets are by their very nature leveraged (in very much a similar way to when you pay a deposit on a property combined with a mortgage). If the price of the instrument you are trading rises 10%, the value of your position goes up from £10,000 to £11,000. You have in fact made a £1000 gain using just £1000 of your own money.
The ability to make bigger returns from a small move is referred to as leverage. Please note that while leverage is very attractive and powerful, it should be used with caution. Effectively you are buying assets on margin, and you can be called to lodge extra margin against your position if it moves the wrong way. This means you can potentially lose more than you have initially invested, and that you do not know your maximum loss at the outset. For this reason, many product providers will offer guaranteed stop-loss mechanisms or limited risk spread betting accounts (Where all positions are tired to a guaranteed stop) – at an additional cost.
Deposit rates start from as low as 2% to trade some of the main liquid indices such as the FTSE 100. This essentially means that returns can be magnified when prices trade in your favour. However, leverage is a double edged sword and losses are magnified in much a similar way. Way of reducing the downside risk include dealing only in markets which you are familiar with, or in ones that are less volatile. You can also stake smaller bet sizes and using stops is definitely a good idea.
Note that the extent of leverage available depends on the instrument you are trading – this is mainly dependent on the size and liquidity of the underlying market on which the trade is base on. For instance, blue chip stocks like Barclays may be traded with just a 5% margin (20:1 leverage) which smaller companies may need margins of 20% or more. Some require 100% margin – which is no leverage at all.
The other point worth mentioning here is that the returns are symmetrical – you stand to gain or lose an equal amount if the price moves equally for you or against you. One quick way to check where you stand is to consider the total market exposure you are opening yourself when you place a spreadbet. For instance, if you open a £10 a point on Rio Tinto at £34 you might only need £1,700 (at 5% margin) to open this trade but you are exposing yourself to a £34,000 trade.
Spread betting is a leveraged product. This means that you’ll be asked to put up a sum representing just a fraction of the total value of your position. For some markets this can be as little as 10% of the value of the underlying market. Your profit or loss, however, will be based on the full position value. So the amount you can gain or lose may be high in relation to the sum you’ve invested; sometimes much greater than your initial outlay.
P.S. Manage things like leverage prudently and don’t be too exposed or greedy. Spread betting is a great product but treat it with respect as losses are usually big and caused by emotion driven deals and over trading.
Note: For what its worth you can spread bet with 100% margin which is much the same as buying the stock – there is nothing spooky about it…no worse or no better than T10/T20 etc…people need to get their head around that as spread betting with 100% margin is tax efficient…trouble is people get greedy and bet their profits and then get it in the nuts when one of their shares goes tits up or the markets go down……whereas they should religiously take off their profits and put it in a separate account for the bad days…oh if life was so simple 😉
The thing that strikes me about spread betting (either way) is that it could possibly make all your hair fall out if you are careless with leverage.. At least buying and holding the real shares is relatively “safe”, in that the maximum you stand to lose is limited to the amount invested!