Leverage and spread betting
Leverage basically means the spread betting firm lends you some of the money required to make the trade. You only need to have the margin amount in your account.
Here’s an example. I want to by 100 BP shares. BP’s current buy(ask) price is 400p per share. Therefore to buy 100 shares I need 400 * 100 = 40,000p or £400.
Buying 100 shares is equivalent to going £1 per point. In a spread betting account the margin requirement for BP is 10%. Therefore I need 10% of the funds in my account to make the trade in BP. So 10% of £400 is £40. The spread betting firm effectively lends you the money required to make the trade so in this case they lend you £360. It’s vitally important that you understand and remember that spread betting is a leveraged product. Here’s why:
I buy 100 BP shares at 400p. Therefore I have £400 invested in BP shares. If the share price falls to 0 then I will lose all of the £400 I’ve invested.
I buy(go long) £1 per point on BP at 400p. My spread betting firm only requires a 10% margin so I only need £40 in a spread betting account to place this trade. If the share price falls to 0 the I will lose all of my £40 in my account and I will owe the spread betting firm £360.
How I said it is vital that you understand this before you take on the challenge of spread betting.
It’s this leverage that allows you to make higher percentage returns on your original investment than you would make in a regular brokerage account. Let’s look at the previous examples again.
Buy 100 BP at 400p. £400 + costs required. BP shares rise to 500p, you sell making a £100 profit (NB. The profit will be less as you need to consider dealing costs and any tax) £100 profit of £400 original investment is (100/400)*100 = 25% return.
Buy £1 per point at 400p. No costs or tax involved only the spread. The margin requirement is 10% so only £40 is required to make the trade. BP shares rise to 500p. You sell out of your position at 500p making a profit of £100. (NB. The £100 is all profit minus any overnight finance charges. With spread betting there are no tax or costs to pay. It’s all covered in the spread.) So you make £100 profit from an original £40 investment. This is (100/40)*100=250% return on your original investment.
Using these two examples you can see the power that leverage offers. Although you have made the same return in monetary terms you have made a much bigger percentage return via spread betting than with a regular brokerage account.
You do need to be careful. This sounds great but the thing you must remember that leverage also works the same way in reverse. Any losses you face are a much bigger percentage of initial funds than in a regular brokerage account.