Spread Trading with Stocks and Shares

Any kind of stock-market investment is a bit of a gamble, but only spread-trading (or betting) is actually classed as gambling for tax-purposes (i.e. no tax in the U.K.) which makes it rather useful, especially for a higher-rate tax-payer.

With most investments (e.g. shares) the stake is the total cost of buying the investment so the most you can lose is all of your money, and the profit theoretically limitless although usually small relative to the initial stake, in any one year. With spread-betting you are just betting on the direction of the chosen market, share, index or commodity etc. E.g. you might want to bet £1 per point that the FSTE100 will rise, in which case you will get the number of points the FTSE rises times the £1 stake minus the "spread" between the buying and selling prices quoted when you start the bet. Similarly if you think the price will fall you can bet the other way, or short the FTSE (which has been useful over recent months, making a profit from the falling stock-markets) The potential gains or losses can be huge compared to the stake, for instance if in the previous example the FTSE moved 100 points you could win or lose about £100. Effectively a £1 bet gets you exposure to £4500 worth of FTSE shares (assuming the index is at 4500 at the moment)

Most spread-trading companies provide a wide variety of things to bet on from house-prices to currency exchange rates, shares, metal prices and bonds. Unfortunately this is where it gets a bit tricky because if you want to bet on an actual price of something, or a "rolling" price the bet is effectively just for today, so if you want to keep the bet open (to roll it over into tomorrow) you have to pay the spread again, which makes it more expensive, unless you always win on the first day or cancel the bet. I find it better to bet on the value of a "future" - i.e. the price on a certain date in the future for which there may be several possible dates available (e.g. I just made a bet on the Gold October 2008) It doesn't mean I have to wait until October, because I can cancel the bet or use stop-loss or limits to make it automatically cancel. That's enough about what spread-betting actually is and how it works (for more information most spread-betting companies give free tutorials or help pages about how their particular web-site works. See the link at the end of the review)

Now I shall discuss some strategies.

Spread-trading is extremely risky as the name implies, and most spread-betters lose money, but it is possible to reduce the risk involved or to use it in conjunction with other investments to reduce their risk. One general equity trading strategy which is often quoted is to cut your losses and run with your winners. When applied to spread-betting this can be interpreted as using a stop-loss close to your opening price and a limit set a significant distance away so your losses are small and the wins are big. In theory, if you get half of your predictions correct you will win more than you lose. If however you set the stop-loss too close to your opening price you can be correct about the general direction of the market and yet your stop-loss is triggered just by the volatility, resulting in many small losses and occasional big wins.

To be more analytical about the probability of either the stop-loss or limit being triggered would require knowledge of the volatility of the index or share you are trading. The volatility of the S&P 500 index is published and can even be traded or spread-bet. VIX is quoted as a positive percentage and represents the expected volatility of the S&P 500 index over the next 30 days. Similarly volatility indices are available for various other markets (although not the FTSE indices) Alternatively the variance of share-prices (or their standard deviation) may be easily calculated using a spread-sheet and historic prices. Volatility is important in determining the ideal relative placement of stop-loss and limit in this or any of the strategies below, but it's a lot of effort to try to analyse the data. A simpler approach is to observe past data for the index or share in question and determine what you consider to be a small and probable daily move and what you consider to be a large and improbable move. The probability of a move of any given magnitude in a financial variable is usually assumed to follow a Gaussian distribution, a bell curve, with high probability of small changes and ever diminishing probabilities for large positive or negative moves in the variable. Deviations of more than 3 standard deviations would be considered extremely improbable (this may not be entirely accurate as very large moves caused by market-moving events are perhaps more common than this would predict and are difficult to predict. The so called "Fat Tail" distribution)

An alternative and possibly lower risk trading strategy would be to set a stop loss at a point that is improbable, but affordable (i.e. in the rare occurrence of it being triggered you will not be wiped out) and set the limit at a point that is highly probable, such that the potential losses are large compared to the possible win, but the probability of the win is significantly larger than the probability of the loss. The probability of a small movement in either direction is far greater than a big move as described above. This results in many small wins and the occasional large loss. The sum of the losses should on average be less that the sum of the wins. It also means you could be wrong a lot of the time, or have no idea about the market direction and still make many small wins triggered by the volatility in the market. It sounds too good to be true, but unfortunately the "spread" between buy and sell prices (effectively the fee charged by the spread-betting company) eats into the small wins and if you get several big losses in a row it could set you back a long way (or at least be very frustrating).

So this may not sound like a low-risk strategy, either and involves a lot of work for little reward, but it is a fairly low-risk way of getting into the trade. Monitoring the progress of the bet and then adjusting the parameters allows the winnings to be improved if the market moves in the way you hoped. You will often be in a small winning position and once you are ahead by more than the minimum spread for the index, you can move the stop-loss to a point that guarantees you a win (if you are using "guaranteed" stop-loss. With a standard stop-loss there is a chance the index will gap-through your stop-loss, but the guaranteed one costs more in terms of a larger spread) The limit may then be moved for the possibility of a larger win. This may be repeated if the index moves in your favour. If the market moves against you however, the bet will be closed with a small profit.

The only truly low-risk use of spread-betting is to hedge against market falls in conjunction with a long-only portfolio. If you have a portfolio of shares, unit-trusts, investment trusts etc. which is highly correlated to an index e.g. the FTSE100, then every day the value of the portfolio will fluctuate but it would cost a lot in trading charges and stamp duty, to try to trade in and out. If a spread-bet is used to short the index when you perceive the index to be high, using what ever method you prefer. e.g. technical analysis (The easiest example is when the market is range-trading and the index hits a resistance level - See this article about Technical Analysis) The share portfolio will have made you a profit which if the market falls will be wiped out again. The spread-bet will however make a profit as the market falls which can be taken once you perceive the market to be relatively low (e.g. a range-trading market hits a support level). A stop-loss can be used a small distance above the opening price, so if the market continues to go up (i.e. breaks through the resistance level in the case of range-trading example) you will still gain from your existing portfolio. This is a good risk reduction method. It has disadvantages versus a put option or warrant, but the returns are tax-free (although losses cannot be offset against CGT) Another advantage of going short is that you make a profit as the market goes down, but you still get the dividends from the share portfolio.

Spread betting is provided by many different financial companies, but interactive investor gives a very good service and is easy to use, with low minimum bets (e.g. 50p or £1 per point) and a free 8-week training tutorial:

http://www.iii.co.uk/spreadbetting/

Financial Spread-Trading is exciting, but don't bet too much as it could quickly cost you a lot of money. I started out with very small bets and practiced for a long time before increasing the stake.

See this article about Technical Analysis

Summary: Be very careful and don't bet to much

Spread-trading is a preferred investment tool for day-trading because it is easy to make short duration bets on market movements. Day trading theoretically involves very short duration trades and day-traders will often use stop-losses and limit orders to make the bet cancel at either a profit or a small loss when certain thresholds are reached. An alternative method is to use fixed odds binary financial spread betting; i.e. bet on an event occurring: Bet that a market index with reach a certain value in a certain period and if it does you receive a defined amount of money (like a sports bet) Not all spread-betting companies are offering this service yet, but it is becoming more popular.

Finance Articles:

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Spread-betting Strategy"
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Technical Analysis
Financial Engineering

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