While many are convinced of the merits of spread betting, the negatives – including gambling problems – are unnerving, writes Caroline Madden

SPREAD BETTING. Drop this phrase into a conversation with someone and you’re likely to get one of two very different reactions. Chances are they’ll either wax lyrical about its vast superiority over more traditional approaches to investing, or they’ll mutter darkly about glorified gambling and recount a cautionary tale about “a friend of a friend” who lost a fortune through spread betting.

So who’s right and who’s misled? Let’s put aside the hyperbole and the urban myths and examine the facts.

Those in favour of spread betting argue that it has several advantages over more “conventional” methods of investing, such as buying shares directly. Firstly, any profit generated is free from Irish capital gains tax and income tax. The only cost is the “spread” – the difference between the buy and sell price. Furthermore, the initial outlay required is low.

Spread betting is not restricted to shares – it is possible to trade a wide variety of asset types such as commodities, currencies, indices, interest rates and bonds. In addition, several spread-betting firms operating here are now regulated by the Irish Financial Services Regulatory Authority.

One of the biggest selling points of spread betting (particularly in light of stock-market movements since the credit crunch struck) is the fact that – in theory – it allows people to make a profit even when markets are falling. Spread betters have the ability to take long or short positions, ie they can take a position that the price of a stock, index or other financial instrument is going to rise or fall.

“It’s like basically trading the market with one hand tied behind your back if you’re going long-only in a market that is falling,” explains Paul Somerville of Irish spread-betting firm Delta Index.

“There is probably nobody in Ireland who is trading equities [directly] . . . who has . . . made money in the last three years,” he says. “The people who’ve made money . . . are the ones who’ve been betting on the market going lower, so they’ve [gone] short [on] the market.”

Rory Gillen, founder of Invest Like the Best stock-market training courses, is adamant spread betting should be avoided by the majority of amateur investors.

“The aggressive advertising of the merits of spread-betting accounts is, in my view, an insult to the investing public with the consistent claims that you can ‘make money in rising and falling markets’,” he says. “Financial spread betting is what it says on the tin – betting . . . It’s a leisure activity and the service provider, the ‘bookie’, makes the money.”

Nonetheless, the ability to go short, coupled with increased financial-market volatility, has resulted in a huge upsurge in the popularity of spread betting. The number of spread-betting accounts open in the UK more than doubled in 2008 to 18,012, and there was a 134 per cent jump in spread-bet trades last year.

Dublin-based firm WorldSpreads, which operates in several markets including Ireland and Britain, reported a 92 per cent increase in average financial bets per day to 5,750 in 2008, and some 3,924 new clients registered with the firm in the year to March 31st, 2009. Clearly many people are convinced of the merits of spread betting, but the negatives are unnerving.

A report prepared on behalf of the UK’s Gambling Commission found that gambling problems are most prevalent among spread betters (compared to other types of activities classified as gambling). It found that more than 14 per cent of adults who had participated in spread betting had run into problems.

Interestingly, spread betting is illegal in the US as it is considered to be a form of internet gambling, which is banned.

Then there is the small matter of leveraging. Financial spread bets are a high-risk leveraged derivative product.

Delta Index’s terms and conditions document sums up what this means: “Leverage gives you the potential for gains as well as losses of many times your initial deposit. FSBs [financial spread bets] offer exposure to the instruments [the underlying financial product being traded] with a relatively small initial margin requirement. However, you can lose more than your initial margin requirement and, depending on the nature of your transaction, your losses may be unlimited.”

When an individual wishes to place a trade, the spread-betting firm will require them to have a certain amount of money, known as the “margin”, on deposit with it first.

The level of leveraging that spread betters can access depends on their firm, and on the volatility of the underlying asset.

With WorldSpreads, for example, the lowest margin required for an individual share trade is 10 per cent.

“So, in theory, a customer could have a €10,000 exposure with a €1,000 deposit,” explains Michael Foley, a director at the company.

Leveraging is a double-edged sword. Although it means very large profits can be made from a much smaller outlay than would be required to buy the underlying asset outright, the reverse is also true. If the trader bets in the wrong direction, they can lose many times their initial deposit in a very short time.

In a risk disclosure statement included in Delta Index’s terms and conditions, the Financial Regulator warns that “margined transactions are not suitable for many members of the public”.

So what steps do spread-betting firms take to vet applicants and ensure they are suitable for the high-risk levels involved?

On its application form, Delta Index requests details of the individual’s employment and their trading history.

“You would . . . normally have to have six months’ experience of trading the markets,” Somerville says.

So spread betting is unsuitable for inexperienced investors?

“Yes, but then it’s not appropriate for them to be investing in the equity market at all,” he argues. “They shouldn’t be in the financial world.”

WorldSpreads requests details including the applicant’s income and trading experience, and asks for a copy of a recent bank statement. Both firms encourage applicants to avail of tutorials, and try to educate their clients before they place their first trade.

The most important piece of armoury at the disposal of spread betters is a “stop loss”. This is essentially an order to close out their position if the loss reaches a certain level, and therefore limit the amount they can lose. Some companies set automatic stop losses, but this is not always the case.

For example, at the moment clients of WorldSpreads set their own stop losses. However, automatic stop losses are being built into a new version of the firm’s trading system, which is being launched later this year.

Despite its soaring popularity, it has not been all plain sailing for the spread-betting industry. For example, in March the owners of UK spread-betting firm City Index were forced to inject £70 million (€81.6 million), as clients defaulted to the tune of £48 million.

Somerville insists Delta Index has “absolutely no bad debts”.

The question of what support spread-betting firms provide to customers who get into trouble or develop problems is a touchy one.

“Is there any advice for people who bought houses at the top of the market because they were gambling? Is there any advice for all the property developers who are going bust? Have we got a property developers’ anonymous society?” he asks.

He does admit that, if Delta Index notices a client is overtrading, “we would have a word with them or we would tell them that we’re going to close their account”.

“We monitor all clients for unusual trading behaviour and, while it is rare, there have been occasions when we have suggested to clients to step back and look at their trading volumes,” says WorldSpread’s Foley.

“We don’t want to lose clients as a result of overtrading. Ultimately, however, it is at the discretion of each client,” he adds.

Perhaps the fairest way to assess the performance of spread betting would be to examine the long-term returns achieved by traders, but firms tend to be coy about divulging such information, “for competition reasons”.

Vincent Digby, an independent fee-based financial adviser and founder of www.impartial.ie, says that as a general rule he would be reluctant to recommend spread betting as an investment strategy due to the potential risk of loss.

“However, for certain clients spread betting can be a reasonable proposition for a limited portion of their investment capital,” he says.

They would have to be financially literate and have a good understanding of how markets and market risk work, he advises.

Furthermore, they should fully understand the potential consequences of leverage, and their financial situation must be such that it could absorb the maximum losses possible.

“They need to be disciplined with their position taking and stop-loss management,” he adds.

Gillen of Invest Like the Best accepts that spread betting offers “something new” for experienced investors, “but this represents probably 5 per cent or less of the investing public”.

Another conclusion that could be drawn is that a fool and his money are soon parted – and all the more quickly if he decides to dabble in spread betting.

Easy spread: the ins and outs of spread betting

WITH FINANCIAL spread betting, the trader stakes a bet on the movement of the price of a financial instrument. For example, you bet that the price of CRH or the Nasdaq index will rise or fall. If the price moves in the direction predicted, you make a profit based on the extent of the price movement multiplied by the stake.

Leverage/gearing: Spread betting allows people to bet on the movement of a financial instrument with substantially less money than the actual full market value of that instrument, so spread bets are highly geared (leveraged) products. Leverage has the effect of magnifying losses as well as gains

Spread: The difference between the buy and sell price quoted to the customer

Margin: The amount of money you have to deposit in your trading account as collateral to be able to open a leveraged financial spread betting position

Stop loss: An order to close a spread bet if losses reach a certain specified level