In a Nutshell
- Spread betting is an attempt to predict how the price of an asset will change in financial markets
- Unlike traditional stock and commodity trades, you are not purchasing an asset in spread betting
- Unlike traditional gambling, the amount of your risk and payout are not pre-specified and change based on the magnitude of the price change
According to legend, the concept of spread betting was developed in London in 1974 by a gold trader named Stuart Wheeler. He was also a well-known obsessive gambler who competed in several World Series of Poker events, so it’s no surprise that he was the father of a financial derivative that helped blend the boundaries between financial trading and betting.
Because of spread betting’s similarity to outright gambling, it is illegal in many areas, including the United States. However, Wheeler first came up with the idea to get around another government ban at the time.
In the mid-1970s, it was illegal to speculate in gold. Trades that were considered solely speculative were outlawed by the British government. Wheeler found a loophole, however. While gold speculation was illegal, it wasn’t illegal to make trades based on the price of gold, as an index.
What Is Spread Betting?
Spread betting has aspects of financial trading, as well as aspects of gambling, combining both into a derivative product. In spread betting, unlike financial markets, investors are not buying any actual asset. You don’t own shares of a company or a commodity. Instead, you are betting on whether the current price of that commodity will rise or fall.
This is similar to straight-up betting. Sports gamblers or race players don’t own any of the entities competing. They are just wagering on who will win or other aspects of the performance.
There is a key difference from gambling, however. When you bet on a horse or a team, you are putting down a certain amount of money. If your bet doesn’t pay off, you lose the amount that you wagered. You’re given certain odds, and if your bet is successful, you know exactly what your payout will be.
That’s not true with spread betting. The amount of your gain or loss depends on the change in the price of the asset you’re betting on. If you guess right, then the larger the price changes, the more you win. If you’re wrong, the larger the price change, the more you lose.
How Spread Betting Works
We’ll use an example from the market that gave birth to spread betting—the price of gold. Let’s say it is currently trading at $1,970 an ounce. Based on your analysis of the world economy and the precious metals markets, you think it is about to go up in price.
In a classic commodities trade, you would buy a certain amount of gold and wait for the price to change. If you bought 10 ounces, you’d pay $19,700, and if the price goes up, you’d sell it for more than that and profit.
With spread betting, you don’t have to put out the price to purchase the gold. You’re just betting on the direction its price will change. You specify whether you think it will go up or down and how much you wager per point (where, in this case, a point is a penny of the per-ounce price).
Example
So, you place a spread bet that gold will increase, and you wager $2 a point.
Let’s say the market opens and gold jumps to $1,972 an ounce. You win your bet and get a payout of $400 ($2 per point x the 200 point—cent—increase).
Normally, investors will need to put down a small percentage of the value of the position. So you may need to put down 10% of what the purchase price would be if you were making the actual trade.
The promise of huge profits with very little initial outlay of money is what draws people to spread betting. Although, the downside is equally large.
Let’s say that some unexpected news breaks that is bad for the gold market, and, instead of increasing, the price plunges to $1,960 an ounce. Your spread bet lost, and the amount of your loss is $2,000 ($2 per point x the 1000-point decrease).
You could also bet that the price will drop, which is generally referred to as “shorting” a stock or other asset. In the above two examples, you would lose $400 if the gold price went up $2 and win $2,000 if the price dropped by $10.
Don’t Lose Your Shirt
Since the amount you can lose is significant—a worst, if unrealistic, case scenario in the gold example is that gold suddenly becomes worthless, and the price drops from $1,970 to $0. You would potentially lose $394,000 ($2 per cent drop for the entire $1,970).
To avoid catastrophes, most trades use stop-loss orders on their spread bets. A stop-loss order manages risk by automatically closing out your losing trade when it hits a certain point. So, if you bet on gold going up from $1,970 at $2 a point and put in a stop-loss of $1,965, then the most you could lose would be $1,000. Regardless of how far the price fell, when it hits $1,965, your bet is over.
Outlawed
If you want to engage in spread betting, you’ll have to travel overseas. The practice is outlawed in the United States, because it’s considered a form of gambling. And, while the U.S. has softened laws on gambling in many states in recent years, spread betting is still a long way from being approved.
There are concerns over the risk of high losses that exist, and the potentially stratospheric payouts also raise concerns over the possibility of illegal market manipulation.
