Spread Betting Techniques that Work and Those That Don't

Let's now look at how to actually go about spread betting and look at some techniques that work and those that really don't. The first take away from this article will be that the techniques that work are hard and the techniques that don't are easy. The bottom line is that spread betting is hard and high risk. If you are not willing to really put in the work you will not do very well at all.

Techniques that Work 

Spread Arbitrage 

Before I discuss this technique I need to make one point very clear: this is not risk free. Nothing in spread betting is ever risk free. Spread betting is entirely based on risk. The thing with spread arbitrage is that when it works it is effectively risk-free but there is the risk that it won't work.

What spread arbitrage consists of is betting on the same event in both directions (i.e. going short and going long). For example you could bet £10 per point on XYZ going up and then bet £10 per point on XYZ going down. The trick is that you place these two bets with different brokers that have different spreads on the bet. This, if done correctly, allows you to profit from the event regardless of what happens.

The risks are:

• Brokers hate arbitrage. If they think that's what your doing they can refuse to place the bet which leaves you exposed 
• The spread and price can change in the time it takes you to place the two bets. This could mean that you have a guaranteed loss regardless of the outcome. 

Being An Industry Expert 

Frankly there is no credible theory of investment that states that the less you know the better you are at investing. Hence the most successful spread betters are also the smartest and most expert people. If you are an expert in a small niche then your estimation of a company or sectors value is likely to be better than that of the market. Furthermore, your predictions of the future are likely to be more accurate than those of the market.

For example if you've been in senior digital marking positions for 15 years you are in a far better place to tell whether Twitter is a short or not.

Note that by industry expert I mean really expert. You really have to know your stuff inside out to outsmart the market and you also, typically, need to go very small to get the maximum advantage from your knowledge.

Distressed Spread Betting 

This technique is actually very high risk potentially but in the hands of an expert it can be reasonably profitable. In order to follow this technique you need to have an expert understanding of accounting (being a chartered accountant helps).

What you need to do here is figure out which companies are at most risk of defaulting and who's value greatly underestimates this possibility. Additionally, you can seek out companies that are already in distress for which a rescue is either impossible or extremely unlikely. A few examples for which this technique could have been applied include Afren plc and Albemarle and Bond (note: hindsight helps here).

Rationing Your Bets 

The biggest problem faced by spread betters is that they bet too often. The more bets you make the more likely you'll make a big mistake. If you ration your bets to focus on only your absolute best ideas where you know that you have an edge then your changes of making money (or at least losing less) are much higher. 

Those that Don't 

Flying by the Seat of Your Pants 

Although I don't have any firm statistics on this I suspect that this is the most common strategy used by spread betters and should hence be addressed.

The temptation is to put on a bet and wait till it goes up a little and then sell out at a nice profit. This may make you money for a while but you will get greedy or make a serious mistake and blow up. If you want examples of this short of behaviour check out Fooled by Randomness by Nassim Taleb.

Dividend Stripping 

This one is actually pretty hard to place. Technically it does work but not by much. I'm also not convinced that it makes sense from a risk-return perspective. 

The basic idea of dividend stripping is that you buy just before a stock goes ex-dividend and sell out just after the ex-dividend date. So you collect the dividend but experience a drop in price once the dividend is paid. 

The fundamental problems are the amount of leverage required and, of course, risk. In order make the profits worthwhile (they are typically very small and measured in basis points) you need to leverage up hugely. This comes with a great deal of risk. If something bad happens between the dates that you buy and close the bet your going to lose money very fast. Imagine, if your leveraged 20:1 (you'll probably have to be) and the stock tanks 20% on a black swan. 

Frankly, I wouldn't recommend this technique because of the high theoretical risk and the small potential returns.  To make a meaningful amount of money doing this you would have to make a large number of bets which greatly increases the risk of one of these bad events happening.  

To summaries and expand on the above points the risks of this tactic are: 

• Very high leveraged required 
• There may be bad news while your position is open which wipes out your gains 
• The stock may fall by more than the amount of the dividend which forces losses on you 
• The stock may fall by exactly the amount of the dividend which means you've taken on risk for nothing 

Hence, I've put in in the "those that don't work" because it is so highly inadvisable. You really shouldn't follow this technique. 

Merger Arbitrage 

This technique doesn't really work with spread betting because you never actually own the shares. The way that merger arbitrate usually works is that you buy shares in the target and sell short the bidder. Once the deal goes through you close out your short position by using the shares you receive from the bidder because your a shareholder in the target. Naturally, since spread betters don't own the shares you can't close out your short with the shares you receive because your not ever a shareholder. 

It is however possible to bet on the probability of an acquisition going through and making money from the spread between the acquisition price and the price of the stock before it closes. The risk is that the acquisition doesn't go though which will most likely cause shares in the target to plummet resulting in large losses. This is just straight up betting. 

Spread Betting on Small Caps and AIM Stocks

It is possible to place bets on small cap and stocks listed on AIM (the Alternative Investment Market). There are numerous advantages of fishing around among smaller companies but there are important disadvantages too, which you must be aware of.

Advantages

The principle advantage of looking into smaller companies is that the market here is less efficient. There is scope here to build up knowledge of a company or sector such that you know more than the market. In order words, your estimate of its value will be better than that of the market.

On the short side the small cap world is the most interesting as many of these companies collapse. If you are an expert in bankruptcy then there are big opportunities (and risks) here.

Disadvantages

One of the fundamental problems with spread betting on small companies is that some of them can't really be shorted (i.e. the broker just won't let you short it) and the stock borrowing costs can be very high. In the case of very high borrowing costs this can totally erode your potential profits to the point where there is no point doing the trade.

Furthermore, you can't bet on every company. Depending on the broker the minimum market cap of a stock which you can bet on can be between £10 and £50 million. Annoyingly when you look at the sub £10 million companies on AIM there are some fantastic shorts that simply can't be shorted.

Though I would argue the most interesting opportunities in small caps are typically on the short side you have to be extremely careful. AIM stocks are very volatile and if your wrong the stock can easily surge several hundred percent. For example if you short a small cap oil company because you think it will run out of cash and it subsequently finds one billion barrels of oil your account is going to be wiped out. Naturally, you could use a stop loss to prevent this but because of the volatility the stop distance will have to be pretty large.

Advantages and Disadvantages of Stop Losses In Spread Betting

Anyone who knows anything about spread betting knows that stop losses are absolutely essential. If you trade without stop losses your taking the worst kind of risk which I like to call "blow up risk". You can of course only blow up once so, regardless of how many wonderful trades you've made if you make one single dumb mistake and leverage it 10:1 or 20:1 then your account can be wiped out. Hence stop losses are simply essential.

However, stop losses do have important disadvantages and problems that you should be aware of. This is not so you can abandon them or start trading without stop losses (that would be very stupid). The reason you need to understand the problems with stop losses is so that you can manage and minimise these. If you don't use stop losses correctly you will struggle to make money (though you won't be wiped out).

Advantages 

• Protects you from blow up risk 
• Helps you manage your portfolio by quantifying your maximum exposure 
• Makes your portfolio more fragile (see the work of Nassim Taleb)
• Can reduce margin requirements

Disadvantages 

• Your effectively shorting the volatility in the stock. If the trade moves against you because of volatility (i.e. not fundamentals such as news or earnings) you will be forced out at a loss. You therefore need a sensible stop distance that takes into account the volatility in the stock. For example if you were short a small cap oil stock (for example, Afren Plc) you would need to have a very large stop distance and sufficient financial strength to withstand large losses as you wait for your thesis to become true (note, it may never). 
• Stop losses incur commission (or a wider spread) which increases your total cost and reduces your profits proportionally.
• May fail to execute or be delayed 
• Guaranteed stop losses increase the spread and therefore cost more. Furthermore, they are not available on all stocks.  

Hopefully you now have a better understanding of how stop losses work and can now start to think about how to mange their downside. Fundamentally what you ideally want is a stop loss that doesn't get triggered by volatility but protects you from big adverse random events (black swans) or just being totally wrong. Unfortunately, even though stop losses are extremely important they are pretty annoying for all the reasons mentioned above.

I also hate how you have to pay to effectively mange risk. I would have thought brokers would want to prevent blow ups. However I expect they are making so much money from the spread that it works out well for them.

Is The Spread Betting Company Betting Against You?

This question is actually pretty complex and controversial. The correct answer is sometimes. In other words sometimes the spread betting company will hedge your bets and other times they will leave them open so that they are effectively betting against you.

The sad reality is that many spread betters lose money in the long run. Hence if you run a spread betting company you can make money continually betting against your weakest accounts. However if you've got professionals on your books, you would really want to lay off all the risk because betting against them is much less likely to be profitable.

The exact hedging policy varies between brokers (they don't usually tell you - or if they do they hide it away somewhere). You can typically find the ones that bet against their customers by reading the annual reports of the brokers. If they make a lot of money don't it they will be sure to gloat in the annual report (and up executive pay) but if they lose money it will all be down to random chance.

Typically a large number of bets will be cancelled out. If someone goes long the FTSE at £10/ point and someone else goes short the FTSE at £10/point the two bets pretty much cancel out (there may be a few points difference due to timing). Hence if the FTSE goes up the spread betting company can pay the long position with the short positions losses (in theory - since they won't close at the same time, but for the time they are both open both positions are hedged). It is also possible for spread betting companies to use CFD's to hedge out client exposures. Big spread betting companies actually employ people to sit at trading desks all day hedging out clients risk. The reality is that a few huge profits by a handful of traders could seriously dent a companies bottom line.

Its also worth noting that its not economical to hedge out the smallest positions. So if there are only a few people trading at £10 per point or less on a small AIM stock there is no point of hedging out the position as the net exposure will be very small. The chances are that the bulletin board loons will be cancelled out by the smart bears.  The bears will end up with all the money which since its short is capped. Though, I doubt the brokers think that way but this happens to be true.

Is Spread Betting Easy Money

This is a claim I've seen made several times on the internet and to be honest I am disturbed by it. To set the record straight I want to state categorically that spread betting is not easy money. I would argue that spread betting is very hard money. Let me explain why...

Your Getting Paid To Take Risk 

What a spread better is really doing is making a bet and taking on the risk that they are wrong or that markets will move against them. The more leverage (i.e. money you borrow to trade with) the more money you can potentially make if you are right but this also works in reverse.

You Can Blow Up Spectacularly

One of the biggest risks in spread betting is that if the market moves against you, you lose money unbelievably fast. Lets imagine you decided to bet that the FTSE was going to go up at £10 point before the crash. This could be just one bet of many in your account - its a pretty standard bet. Now, lets imagine you finally get out 2000 points down. At £10 per point your down £20,000 which will really hurt. You will probably gets lots of margin calls you can't meet and hence all your trades will be forcibly closed regardless if they are up or down.

Don't Be Fooled By Demo Accounts 

Why do brokers offer demo accounts? It's not because they are nice or looking to educate people about the markets. No. Unsurprisingly, as practically every broker has invested in developing and aggressively (not to mention very expensively) advertising them; you would expect that they make a lot of money for the brokers. The point of demo accounts is to convert site visitors (many of whom are paid for) into real money betters.

I created this demo account and put on a simple bet. I used the maximum margin, no diversification and no stop loss. This is a very dangerous bet. However, by change I made a huge amount of money. Therefore I'm a genius and should get a real money account. Please note the sarcasm.

The real danger with spread betting in a demo account is that you will take too much risk because you can’t lose real money and hence may, by random chance, make a lot of ‘money’. But why is this bad?

The reason is that you may make a lot of money which will convince you that what you're doing works and then you will get a real account and blow up. Don't let a demo account make you overconfident. If you are so much of a novice that you need a demo account then it is luck not skill that explains your "profits".  

Though, I'm not against demo accounts. If you are going to spread bet for real using a demo account is a must. You cannot afford to make silly mistakes when trading for real on margin. When you are first confronted by a trading station it is pretty overwhelming and confusing. Demo accounts let you get used to how things work and get a feel for how the game is played. 

I really hope that this article has convinced you that spread betting is far from easy. In the wrong hands it is a disaster waiting to happen. Don't believe any claims that it’s easy or that anyone can make money. Successful spread betting is a minority sport and its certainty not for widows and orphans. 

Merger Arbitrage In Spread Betting

NOTE: This is a very complex strategy which has numerous complexities rendering it only practicable for the most sophisticated spread betters.    

One of the most famous trading strategies used by hedge funds is merger arbitrage. This can be a highly profitable strategy and is regularly used by hedge fund titans like Carl Icahn and John Paulson. The question is: can you carry out merger arbitrage with spread betting? The temptation is of course the allure of lower risk profits and the fact that spread betting is one of the only ways a UK retail investor can go short.

Unfortunately the answer is, in general, no. With extreme care and the willingness to take on extra risk it is technically possible to sort of do it. The fundamental problem is that in order to pull off a merger arbitrage you need to actually have the shares at hand. You should be aware that spread betters never actually own the shares in the company that they are betting on.

The way merger arbitrage works is that you buy shares in the target company (company A) and sell short the shares in the company that's doing the takeover (company B). Once the acquisition goes through you use the shares in B you get to cover your short. Your profit is the difference between the share price of A and the price that A is actually acquired at. Unfortunately, when spread betting you don't actually get the shares to close out your short - everything is settled in cash.

On the other hand it is still possible to bet on the completion of the merger but this isn't arbitrage (its just betting). If you have reason to believe that the merger will go through you can bet long and make the difference between the acquisition price and the level at which the stock is trading. If, on the other hand, you don't think the merger will happen then you can go short and hope the stock falls when the acquisition/merger fails to go through.

Its essential to grasp that the above is, of course, betting and not arbitrage. The prices that the stocks reach post merger announcement represents the probability of the merger/takeover going through and can be reasonably efficient. Hence you need to have some compelling reason why you are more likely to be right than everyone else. There are real advantages in trading and investing if you are an industry expert.  

How Can You Lose More Than Your Initial Investment When Spread Betting?

Now listen up - this is extremely important. It is entirely possible that you can lose more than your deposit. This is what I call "blowing up spectacularly" and I consider this to be the number 1 risk in spread betting. In trading and investment risk management is important but in spread betting it is the single most important thing. If you cannot manage risk you will never do well at spread betting.

The Classic Problem 

Strangely the biggest advantage of spread betting is also its biggest disadvantage. The advantage is the fact that you can employ leverage which makes winning trades amazingly profitable but conversely losing trades become insanely expensive. The big problem is that the leverage can wipe your account out spectacularly quickly.

To illustrate my point consider this graph. In this hypothetical example the trader has made a fortune taking risk and being constantly right. However, after all the traders successes they make one mistake and its game over.

If this were to happen in real life what would likely happen is that the owner of the account would either have to meet some big margin calls quickly or all of their positions would be closed out. If they were closed out (or expired) at time=6, the trader would have to write a cheque to their broker for £5000 to get their account balance back up to £0. Ouch! 

Some Real World Blow Up Examples 

Lets work through two real word examples to help us understand, in realistic terms, how an account blow up could potentially happen. We will look at two simple examples:  a long spread bet on the FTSE 100 just before the crash and going short ASOS.

Long FTSE 100 Pre Crash

Let's see "the classic problem" in action. Now, lets imagine that you make a simple, innocent bet on the FTSE going up. In the long run the FTSE will go up, surely. Hence you may think your not taking much risk. However, had you went long on the FTSE 100 you could have been totally wiped out. Let's work through a simple example to show you how this can happen.

So let's say you went short at the pre-crash high of around 6,600 at £10 per point. The index then fell to 3,500 soon after. Hence your losses would be:

Points Lost: 6600-3500

=3100 points 

Money Lost: 3100*£10 

= £31,000

But what deposit would you need to hold this position? Now, this is where it gets very scary. Typically when betting the FTSE 100 the margin factor is around 23 (that's what I got quoted when writing this). Hence the deposit needed to open the position without a stop loss is: 

 Margin Required= margin factor * £/point 

=23*£10 

=£230

Now, I did say its scary. You see that theoretically you could open a position with £230 and go on to lose £31,000. Hence you could lose in this bet far more than your initial deposit. Again, be careful when you spread bet. 

Shorting ASOS

To a value investor ASOS has been a total mystery. At every stage in its history it has been on paper - massively overvalued. However, this one has been a nightmare to short. Its the perfect example of the old short selling adage:

"Markets can remain irrational longer than you can remain solvent" - John Maynard Keynes

If we look back to 2011 (the last year I can access financials for without having to dig up old annual reports) we see that ASOS had earnings per share (EPS) of 13.7p (diluted). The share price at the date that this EPS was announced stood at a whopping 1700p (£17). This is an insanely high valuation that assumes extremely high and sustained future growth. The stock clearly looked like a short.

However the stock actually delivered seller growth and by August 2014 had EPS of 44.6p. However even with this EPS paying £17 is still pretty expensive. At the time that this EPS was reported ASOS stock stood at around (2800) £28. Worse still it peaked at 7050 (£70.50).

Lets imagine that you bet at £10 per point when the shares were at 1700 (£17). If we ignore the spread and financing at the peak your losses would be as follows:

Points down: 7050-1700 = 5350 points 

At £10 per point: £53, 500 loss

Remember that you have to ensure that the position is financed at all times so you would have to meet some pretty big margin calls to prevent the position being closed out while ASOS was at its peak. Let's now look at the margin required. The data we need to start with is: 

Margin rate for ASOS at time of writing = 10%

Betting at £10/point is equivalent to 1000 shares

In order to open the position we would only need to put a deposit that is at least 10% of the position. If your balance fell to 9% of the position you would get a margin call because you are not meeting the margin rate. Though of course we would need enough to pay financing (if the finance cost for shorting is negative due to interest rates or borrowing costs) and some headroom for adverse price movements. In theory you could open out this position with a deposit of:

Total Position Size: 1000*£17

= £17,000

Hence the minimum deposit required will be:

Margin Required: £17,000*10%

= £1,700

If you didn't want to close the potion (i.e. you wanted to follow though on your conviction that ASOS was overvalued) you would have to keep the position funded. Note that they say "initial investment" this means that additional funding may be added to maintain the position. At the peak this would get very expensive: 

Peak Position Size: 1000*£70.50

=£70,500 

 Margin Required: £70,500 *10%

=£7,500

Hence you would be on the hook for the difference between your deposit and the new margin requirement: 

Additional deposit needed: £7,500-£1,700

=£5,800 

Hopefully this extreme example will show you how risky spread betting can be if not done carefully and with an eye to risk management. Note that in this example you initially deposited £1,700 and could potentially have lost £53,500. You would also be hounded by your broker constantly asking for more money (up to £5,800) or else they will close out the position and force you to pay your losses. Though hopefully you would have closed out your position long before then.   

The reason I picked such an extreme short example is to illustrate an important point to remember about short selling which is that:

Short selling has a theoretically infinite risk. When you are long a, it stock can only go to zero but when short it can go up and up and up. Also when a short position goes against you the position grows as a proportion of your portfolio. 

How to Manage Risk  

These examples, though extreme are very important. When spread betting you have to be prepared for the unexpected otherwise you will get into trouble. From collapsing oil prices to Swiss central bank shocks; the risk of unexpected shocks is ever present and hence you have to be ready for them. 

The main tools you need to know are: 

• Stop Loss - i.e. dump the position before huge losses build up (so you get out a smaller loss)
• Guaranteed Stop loss - you get out of the position regardless of market positions. If your broker can't cover your position (i.e. not enough liquidity in a small cap) that's the brokers problem not yours.  

I discuss stop losses in more detail in various articles around the blog.