While spread betting is attractive on a number of key grounds, it is by no means a foolproof way to investment riches. Just as spread betting can deliver high returns, so too can it prove to be an expensive way to learn the lessons of the difficulties of trading. Generally, the disadvantages of spread betting can be covered and mitigated to a large extent by sensible, consistent trading, but that’s not to suggest the risks are not substantial, and it is vitally important to pay heed to the dangers of spread betting before committing to a particular transaction.
Corresponding with the advantages, our treatment of the spread betting fundamentals would be incomplete without a round-up of the key disadvantages and risks that spread betting throws up. Let’s take each of the most significant in turn.
Disadvantage of Leverage
While leverage can be financial spread betting’s greatest advantage, leverage can also be considered to be its most significant drawback, giving rise to the possibility of seriously hefty losses. Because leverage in spread betting works on the basis of multiples, choosing a stake amount becomes a paramount consideration, because the extent of the losses you can face are determined by the amount of exposure you take to a given position. What worse, the fast pace of earnings and losses in spread betting make it possible to lose your entire trading account in a matter of minutes, courtesy of just a few wayward trades.
Unlimited Liability in Spread Betting
Similarly, your losses aren’t just limited to your original stake. When you buy a share, the worst outcome you can possibly expect is that you lose 100% of your investment. With spread betting, you can lose 200%, 300%, 1000% in a matter of minutes, all as a consequence of leverage, thus the risks involved in spread betting are comparatively much larger than with other trading styles and can result in problems far beyond the consumption of your trading capital.
Funding Costs
The funding costs associated with spread betting on credit can also amount to a disadvantage and a disincentive to trade. Financing costs are calculated on the basis of the total size of a transaction rather than on the basis of the financing portion, which as a result can lead to higher financing charges, particularly for positions held over the longer term. When these costs are factored in to the equation and are offset against trading profits, they can have a dramatic impact on the trading equation.
Capital Intensive
Because spread betting is so highly leveraged, it is also deceptively capital intensive. A bet with stakes of £1 for example might require a trading account with £500 of trading capital to be a safe, sustainable transaction. This is a direct result of the risks of spread betting, and it is absolutely vital that capital is preserved in order to guard against overleveraging and overtrading. The net result is that spread bettors often find they are holding on to a higher proportion of their capital than they might like, in order to guard against the risks of wayward positions.
Defined Expiry Date
Spread betting transactions, unlike shares or commodities or most other assets, have a defined expiry date, usually the end of the day, at which point the position will incur an additional fee for staying open. That makes it virtually impossible to capitalise on the natural drift of pricing upwards, and puts an artificial time limit on the duration of a spread betting transaction.
No Ownership
Spread bettors, unlike other types of traders acquire no ownership or interest in the underlying asset or market. Rather than investing in the underlying market directly, spread betting takes place on the basis of the market price, hence why there are multiple tax advantages on spread betting versus regular trading. This means the trader acquires no rights of control or influence on the underlying market, and is merely a third party passenger with no voting rights, no impact on asset price and no direct role to play in the market, no matter how heavily you are exposed to it.
Volatility
The spread betting markets are also extremely volatile, with dynamic pricing and constant market fluctuations making it a fast paced, fast moving place to trade. While this can be a good thing in terms of giving rise to profitable trading conditions, it can also be a significant disadvantage, and means that markets and prices can react severely in either direction. This can also cause significant losses to amass over a short period of time, and makes spread betting ultimately more risk than many alternative trading styles.
The risks of spread betting are multiple and diverse, and as with most things there are some potential downsides to trading through spread betting as well as advantages. For traders looking to make their way in the spread betting market, it boils down to a case of how effectively you can mitigate risks while exploiting the opportunities thrown up by the markets. By understanding the potential pitfalls and how to avoid them, you’re more than half-way towards a successful trading career.
Take Control of Your Risks: Set Stop Losses
The upsides in financial spread betting are potentially very significant, with unlimited gains on offer for traders who get behind the right positions. On the flipside, the dangers of spread betting are also unlimited, to the point where even one misplaced trade, left long enough, can destroy the entire trading account. Those traders that make the most of their capital and look to trade in a sustainable, long-term way need measures to counteract these risks and capital threats, the most common of which is the stop loss. But why are the risks in spread betting so high in the first place, and how can these risks be tempered to best effect?
Why Spread Betting Is High Risk?
Financial spread betting, similar to sports spread betting, offers returns and calculates losses based on multiples. For each point movement the market shows in either direction, traders either earn a multiple of their stake or lose a multiple of their stake. In this sense, 1 point = 100% returns on the original staked amount. While this degree of leverage is a positive on the upside, allowing traders to quickly rack up significant wins from profitable markets, it can have equal strength on the downside, with each point the market falls away another multiple in liability.
This fast-moving, cumulative effect is made worse when you consider that losses (and gains) are uncapped. This means that traders can earn millions, or they can lose it all – your investment capital, your car, your home. In this sense, spread betting is a deadly serious business, and one that should be regarded with the utmost respect and caution.
Making Use of Stops
Undoubtedly one of the best ways of putting a limit on potential losses, and structuring the parameters of the trade is through the careful deployment of stop losses. Stop losses are trigger orders that sit underneath the current market price, with the effect of automatically cancelling out positions when the market hits a certain level. This puts a cap on the total potential losses, and allows traders a degree of automation in handling the downsides of their transactions.
Important Notice: The best spread betting platform in the UK offer stop loss orders, so make use of them.
While stops can be useful, it’s important to always remember to leave breathing space for your positions. Where stop losses are set too tightly, minor adjustments and fluctuations in the market can be enough to trigger the loss, and therefore render a position as a liability without giving it a proper chance to develop profitably. In this sense, positioning stop losses is something of a balancing act, to ensure you get capital protection without squeezing out your chances of a profit.
Using stop losses as part of your trading strategy is an invaluable way to cap risks and put limits on the extent of exposure possible in any given trade. While stop losses can be a costly feature when used to widely, the importance of capping the downsides cannot be underestimated in protecting capital and allowing profitable spread trading.