Because forex is the most liquid financial market worldwide, it makes sense that there are so many trading this instrument. From options, swaps to futures and forwards, investors and traders have plenty of options at their disposal.
A relatively unknown method of speculating in the markets is spread betting, a unique type of forex trading. Fear not, it’s not difficult to understand as we will cover how this derivative works, where it’s popular, and the advantages and disadvantages.
What is spread betting in forex?
Spread betting in forex is a method of speculating by ‘wagering’ or opening a position based on whether currency prices will appreciate or depreciate without owning the underlying asset. Hence, this is another form of a CFD (contracts for difference).
In traditional spot forex, traders don’t technically own the underlying asset as well; so, what’s the difference with spread betting? Fees-wise, traders only pay the difference between the bid and ask price, also known as the spread.
Hence, there are no commissions. In spot forex, it’s common sometimes for you to be charged a small spread and commission depending on the type of account being traded. Perhaps the main distinction is spread betting profits are tax-free, unlike traditional spot forex.
It’s one of the reasons why this market is particularly prevalent in the United Kingdom and a few other regions since their countries have favorable laws towards spread betting. Also, such a market is the closest thing to betting with currencies and is technically considered a form of gambling instead of investment.
Like ordinary spot forex, you spread-bet through a conventional broker who may offer this trading approach on other markets like stocks, indices, commodities, and bonds. Moreover, leverage is involved, the ability to go long (buy) and short (sell), and funding charges for positions held overnight.
IG is credited as the inventor and the first brokerage globally to offer financial spread betting in 1974.
How does spread betting work?
Let’s explore how this trading approach works in currencies with a simple example. When you open a position in spot forex, you set your stop loss and take profit or manually exit the trade at a loss or profit based on the number of pips.
With spread betting, we quantify value differences according to points. For instance, the market price would be displayed as 12544.0 instead of 1.25440. The digit after the decimal is measured as a point.
As most spread betting occurs in the UK, brokers from this region typically use a £1 or £10 per point measurement. Of course, the currency will differ with a firm from a different nation, though it will be 1 or 10 units of that currency per point.
Now let’s consider a hypothetical scenario where a trader wanted to spread-bet on EURUSD by taking a short position on believing this market will fall. After the spread, the selling price for the euro is 11582.0, and the trader decides to set their loss limit at 25 points and profit target at 50 points.
Two scenarios may occur:
If prices were to move in their favor by going to 11582.50, they would gain a profit of £500 (£10 X 50 points); if the market moved against them to 11581.75, their loss would be £250 (£10 X 25 points).
Something else worth noting is how the leverage is calculated slightly differently with spread betting. As we know, having leverage or margin means you only put down a reduced fraction of the entire notional value for the underlying traded market.
Typically, a broker presents a margin factor as a percentage in spread betting. One of the most common is 3.33% (equivalent to 1:30 leverage). So, if a trader wanted to open the position in the previous example, they would need to deposit £3856.80 (3.33% X £115820) or a currency equivalent.
Pros and cons of spread betting
Let’s see the main benefits and drawbacks of spread betting.
Perhaps the most attractive advantage with spread betting is that no taxes or even stamp duties apply because countries allowing this derivative consider this gambling instead of speculative investing.
Most countries will apply a form of capital gains tax for any spot forex profits you derived above a certain threshold. In most nations, most gambling, such as sports betting and the like, has naturally always been non-taxable.
Of course, this exclusion may not apply to all countries, and hence, an investor needs to confirm any relevant laws with their native authorities. As a CFD product, you also have the advantage of leverage which can amplify your gains with a smaller deposit as in spot forex (although, of course, losses can equally be magnified as well).
One of the main downsides is the leverage is drastically lower. Hence, your capital requirements to open the same position with spot currencies are a lot higher. Like most derivatives, you have to be aware of the overnight costs and perhaps larger spreads on certain occasions.
Another drawback is the understandable limited geographical reach for spread betting. There are only a handful of regulated brokers in a few countries offering this product.
The Founding Father of the United States, Benjamin Franklin, once said the only things certain in life are death and taxes. Hence, traders who live in countries where they don’t need to worry about Uncle Sam in online trading may consider spread betting.
Ultimately, spot forex and spread betting share several similarities. Both are CFDs of real-life currencies and move according to their prices. Traders take no actual ownership of the underlying asset and need to pay spreads and swaps where applicable.
Spot and spread betting use leverage, with the former employing significantly more. The main differences boil down to how each is perceived, where one is seen as gambling while the other is a speculative investment, hence the tax exclusions.
Nonetheless, traders or investors should tread carefully in these areas and confidently master all the technical aspects of speculating with such markets.