Spread betting provides (what is spread betting?) 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.
The Spreads: Key Points
The width of the spreads on offer on a given transaction outlines the price of the trade, in the form of the broker’s commission. The spread is the distance between the bid and the ask price quotes in a market and reflects a number of key considerations and assessments broker side to prevent traders with the foundation of their transaction. Knowing the size of the spreads in a potential market, and how easily they can be overcome to generate a return is important in determining how best to allocate capital. But what are the factors brokers are thinking about when it comes to formulating their spreads, and are there ways in which traders can seek to reduce the costs of their trading?
Liquidity
Market liquidity and trading volumes are key factors in determining spread pricing. Markets that are less liquid or are traded in lower volumes tend to pose a greater risk to brokers, in that they are less likely to be reflective of true underlying value than active, heavily traded markets. In this sense, more liquid markets will have narrower spreads, because the market is more transparent and represents less of an unknown quantity to the broker quoting on it. Most major securities markets benefit from low spreads for this very reason, given the extent and volume in which they are traded daily.
Volatility
Volatility is another issue traders should concern themselves with in identifying low spread markets to trade. Markets in which there is greater volatility (i.e. a wider cycle of movement between peaks and troughs) expose brokers to much larger potential risks, in that positions have the ability to be heavy winners on both sides of a market. This means that brokers need to be more certain that their trading will turn a profit, and as a result leads to an increase in costs for traders.
Risk
Risk and general market uncertainty also contribute extensively, with brokers naturally as keen as possible to avoid running up unsustainable liability. In markets where there is underlying risk or periods of uncertainty as to the economic, market and geopolitical future, brokers will look to cover their own backs with wider spreads, making it more expensive for traders to do business on a transaction-by-transaction basis. Conversely less risky markets can be priced in a way that is more competitive, given that traders benefit from the same degrees of protection as traders when investing in more stable assets.
The costs that contribute to determining spreads aren’t set in stone, but brokers generally look to strike a balance between covering their expenses, making a profit, and pricing competitively as a means of finding new customers and retaining old ones. One way in which traders can minimise the spread commissions they incur is through comparing different brokerage options across markets. By trading through a number of competing platforms, traders can cherry pick the best spreads for the relevant markets, to ensure they’re squeezing maximum juice from their investment capital.