Spread betting, day trading and futures explained in plain English
Have you ever been attracted by some of the more exciting financial opportunities often written about in the media? Spread betting, for instance? Day trading? Futures? Those promoting these strategies speak of the potential for massive gain. It is possible, they claim, to double, treble, quadruple your cash or more in the shortest possible time. The idea of making a vast profit in a matter of weeks, days, even hours, is of course extremely tempting. So this week I thought I would explain how these much publicised financial instruments work.
Spread betting has garnered a great deal of attention over the last few years. Its appeal lies in the fact that it allows you to bet cheaply on the rise or fall of an asset without actually owning it. Historically, if you wanted to trade in different markets such as international shares, indices, property or commodities you had to use a variety of different methods to do so. Not with spread betting. You can get exposure to a market instantly, with only a small deposit typically about 10% - 20% of the value of your bet. In other words, a 1,000 bet could cost you as little as 100. What's more, there is no commission to be paid, no stamp duty on dealing and no tax to pay on winnings.
How does it work? A spread betting firm will predict where an individual share or market will stand at a future date or period of time. They won't name a specific price but rather an upper and lower range. This range is referred to as the spread. You can then bet on the spread in one of two different ways. If you expect the share or market to be above the spread you can buy at the high end. If you expect the share or market to be below the spread you can opt for the low end. This is best explained with an example. Supposing a spread betting firm is quoting a spread of 6,100 6,110 for the FTSE 100 during January 2007. If you feel this is a bit pessimistic you might decide to bet 100 a point above 6,110. Any time before the end of January you can close your bet and take your gain or settle up your losses. Let's say you are right and the index climbs 50 points to 6,160 at which juncture you close the bet. You will collect 5,000 (50 points x 100). Let's say, on the other hand, you are wrong and the market falls 50 points below the top end of the spread to 6060 (6,110 less 50). Your error of judgement is going to cost you 5,000! Basically, the more the market moves in your direction the more you stand to gain and the more it moves against you the more you stand to lose. It is possible to limit your losses by paying for something called a guaranteed stop-loss' but the cost is usually so high as to make the chance of gain almost impossible.
Day trading first came into the news about six or seven years ago as a method by which small, private investors could make money from the stock market. The name says it all. Day traders rapidly buy and sell stocks throughout the day in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits. It was the result of two phenomena. The first was greater market volatility with prices of some stocks especially in the information technology sector rising or falling by a substantial amount each day. The second was lower dealing charges allowing investors to buy and sell for a relatively low cost. At the heart of the concept is the idea that you need to close your position at the end of each trading day taking your gains or losses then and there.
Putting your money into a futures or commodity contract also holds out the promise of substantial gain. As with spread betting, commodity trading involves predicting the price of a particular commodity anything from gold to frozen orange juice, and silver to pork bellies at a specific point in the future. And, as with spread betting, gearing plays a big factor in the activity. Its history, however, is rather more respectable. These contracts were originally a way for manufacturers to reduce their risk. For instance, in the days when silver was more important to the photographic industry than it is in this digital age a company like Kodak might contract to buy a set amount of the metal a year before they actually needed it at a pre-agreed price. On making the contract they would traditionally pay a deposit usually 10% of the total contract value. Before long it was realised that this was a way in which anyone not just manufacturers - might make a great deal of money. How? Like this. Let's say you think silver is going to go up in price. You pay 10,000 to purchase a 100,000 contract. If you are right and silver goes up 10% you make 10,000 doubling your money. On the other hand, if silver falls 10% you lose your 10,000. And if it falls 20% you would lose an additional 10,000.
You may have noticed that in describing these three different methods by which it is possible to make or lose a small fortune I have not once used the words investment' or investor'. Spread betting, day trading and futures are all out and out gambles.