Spread betting is a tax-free method of speculating on the future movements of many financial instruments, such as stock prices, commodity prices and indices such as the FTSE 100 or Nasdaq. Unlike traditional share ownership, you can speculate and profit from movements both upwards and downwards in prices, while never actually holding the shares.

Although the spread betting companies use very sophisticated financial models to allow this market access, in practise spread-betting is very simple.

You simply choose an instrument, such as a single share price or index, choose the direction in which you think it is likely to move (and in what timeframe) and an amount you wish to bet for each point it moves in your direction.

A simple example:

You think that the FTSE 100 is overvalued at 5850 and wish to bet that it will fall today. (Betting a price will fall is known as a 'sell' bet and betting it will rise is known as a 'buy' bet)

You select your instrument (ftse 100 daily bet), and place a 'sell' bet, and select the amount per point, in this case £2.

The spread betting provider offer a 'bid'(buy) and 'offer' (sell) price. In this example it may be 5851 and 5849, while the underlying price is 5850. This gives a 2 point 'spread' which is where the company make their profit; If you were to buy and then sell immediately without any price movement, you would be £4 (2*£2) out of pocket.

Lets say we buy the bet at the 5852 level.

If the market falls, and the ftse drops 20 points to 5830, the bid and offer change to 5831 and 5829. You can then 'buy' back your 'sell' bet to close the deal (it can be at any time up to the end of the trading day).

In this example you would have 'sold' at 5849 and 'bought' at 5831 - a differnce of 18 points, giving you a profit of £36. (£2*18)

If however the market rises by 15 points to 5865, the bid and offer will change to 5866 and 5864. If you were to close the bet, you would have sold at 5849 and bought at 5866 - a difference of 17 points - and hence would have lost £34. (£2*17)

Due to the volatility of some markets, a stop-loss is recommended for many types of bets. This is a level at which the bet will be automatically closed if the market moves against you. Often these levels may be subject to some 'slippage' if the market moves particularly quickly, and it is not possible for the spread-betting company to close the position in the market. Most companies now offer guaranteed stop-losses, which are guaranteed to close at a certain level. However they usually charge an extra point of two of spread for the priviledge. This effectively transfers sme of the risk of fast-moving markets to the company.

A trailing stop is a moving stop that follows the price of an instrument, ensuring that any sudden movement does not wipe out profits already made - effectively locking in profits.

Example:

You think that a rising Oil price will bolster the profits of BP over the coming months, and hence increase the share price.

In July, you place a 'buy' bet on BP.L to end in September (you can cash the bet in at any time up till the end of September). The current share level is 590 pence.

You are offered the following price on BP.L September.

Bid: 595 pence
Sell: 585 Pence

(Generally the further away the end date of the bet, the higher spread is incurred)

You Place a buy bet at £10 a point at 595 pence.

You Place a trailing stop 20 points away from your buy price. (575 pence)

If the price was fall to 575 pence immediately, with the bid/offer at 580/570 your stop would be hit, and you would lose 595-570=25 * £10= £250

However, if the price was to raise to 670 (675/665) pence, you would be in a position to close at 665-595=70 * £10 = £700

If during this time, your trailing stop would have moved to 650 - ensuring that even a fast downward movement would not wipe out all your profits. Even if the market for BP shares crashed overnight, your guaranteed trailing stop would ensure that you profit by 650-595=45 * £10 = £450.

Leverage is a term used for trading on 'margin' or borrowed funds.

Let us consider the following bet:

The FTSE is currently at 6150 with a bid/offer of 6151/6149 We place a bet that the FTSE will rise:

We BUY the FTSE daily @ 6151 with a guaranteed stop-loss at 6131. As our maximum loss from this bet is £20, this is all we will need in our account to place the bet.

However, the price movement within the day is equivalent to having £6150 invested in the index, allowing for vastly increased profits and losses.

A common use for spread betting is to hedge (offset risk) in an existing portfolio.

As an example.

An investor holds 100 ounces of gold, which after a rapid run-up is currently valued at $1000 an ounce, giving a market exposure of $10000. The investor thinks that the price is likely to temporarily fall over the coming months, but does not wish to sell due to trading costs, and wishes to lock-in his profits.

As it stands, for every dollar the gold price falls, the investor stands to lose $100.

Therefore that investor chooses to place a sell bet for $1 per cent on the gold price.

Any drop in the investors original portfolio will be made up for by profit on the bet, conversely, if the gold price continues to rise, the profits on the investors original portfolio will be consumed by the losses on the bet - effectively making him 'market neutral' for the duration of the bet.