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.