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.
Disadvantages of Spread Betting
Corresponding with the advantages, our treatment of the spread betting fundamentals would be incomplete without a round-up of the key disadvantages that spread betting throws up. Let’s take each of the most significant in turn.
Disadvantage of Leverage
While leverage can be 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.
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.
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. This is built in as a security measure for the spread betting broker, to prevent runaway losses which would inevitably cripple their business.
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.
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.