How Spreads Are Calculated
Spread betting provides a variable opportunity for traders to generate a return, defined by the points spread and the distance between the spread and the closing price of the base index. For some transactions, earnings can be significant, with the stake multiplying with every PIP (percentage in points) movement in a favourable direction. With such a high earnings potential for traders, the potential risk exposure for the brokers would at first seem significant, and it would appear that super-successful traders run the risk of causing serious financial damage to spread betting brokers as they generate their income. In actuality, the construction of the spreads offered is designed, much like a bookmaker's odds, to weigh in favour of the house, to help better guarantee the profits of the broker.
Make no mistake about it - brokers are no slouches. They invest heavily, both in time and resources, in analysing and understanding the markets they quote, and anything short of this dedicated, focused approach would be madness. The spreads that are quoted on the various different markets offered by spread betting brokers are designed to deliver two key benefits to the broker.
Firstly, and perhaps most obviously noticeable for the trader looking at the prices on offer is the spread itself. When quoting markets, brokers will quote a buy price and a sell price, with the middle ground unaccounted for. This middle ground, represented by the gap between the buy and sell price, is a built in commission for the broker, and delivers the first earnings opportunity from a transaction for the broker. For example, if the spread between the buy and sell prices is 2 PIPs, the trader starts the transaction 2 points down (or 2 times their stake in debt to the broker). This serves as a form of handicap for the trader, who must by definition gain 2 points to break even on the transaction.
Secondly, in calculating the spreads they offer, spread betting providers also build in a much more subtle handicap for traders, but one that is nevertheless of equal importance to traders looking to make a successful transaction. The spreads that are quoted take into account market forecasts and projections made by the brokers, for example, the spreads are always wider on more volatile and illiquid assets.
You could be forgiven for thinking that the calculation of spreads makes spread betting a less attractive investment style. In fact, the opportunities for profiting from spread transactions remain in spite of these handicaps, and simply mean traders have to work harder and smarter in order to deliver their return.