Is Spread Betting Gambling?

This isn't as easy to answer as you might think. The simple answer is, of course, yes. The vast majority of people carrying out spread betting are gambling. It's in the name: they are making a bet. If you fail to understand this then you are in for a real shock.

The truth is that spread betting is probably the highest risk way to gain exposure to the markets. Fundamentally, what you are doing is borrowing money at interest to speculate on the direction of some asset. Get it right and you win, get it wrong and you loose. Worse still you can be absolutely right in your research but still lose huge amounts of money. How can that be possible?

Let's consider an example. Lets imagine that your a genius when it comes to analysing companies and you (like Jim Chanos and a few others) figured out that Enron was a fraud and went short. Lets say you did it at a share price of $40 with a bet at $100 per point you would make a huge amount of money tax free when the whole thing collapsed.  However, prior to its collapse Enron surged to $90 dollars per share which would have wiped almost everyone out.

Here is a screenshot of an example series of trades I made up in a demo account. Notice how it would be tempting to pocket the £2,921 for the Nikkei long position but observe how the portfolio has been blown up by the Australian short (rule 1 of spread betting is don't blow up). If this were real I'd be on the line for some pretty nasty margin calls. It would also be very psychologically difficult to close out the position at a £9,320 loss (even though it could, in theory, go much, much lower).  Oh, did I mention that at the time I took this screenshot the account was 2 days old? 

Let's just run the numbers for the Enron example. If you are betting at $100 per point you have a position that is equivalent to 10,000 shares or $400,000. So when Enron went to zero you will win $400,000 which is pretty good going. However when it surged to $90 you'd be showing paper losses of $500,000 even though you were 100% correct in your analysis. You would also have to pony up for some pretty hefty margin calls ($50,000 at a 10% margin rate) or you'd have your position forcibly closed.

This is a major problem that few people really think about. Being right is not good enough, you have to be right and really back your convictions and conversely exit positions when you are shown to be wrong (which requires an open mindedness and scepticism that few people posses). Frankly, hardly anyone is psychologically suited to spread bet perfectly rationally which makes "non-gambler" spread betters extremely rare.

Furthermore, on the psychology front, spread betting has a habit of turning most peoples brains to mush. The markets move too quickly and this leads people to trade too frequently which erodes their capital through the transaction costs (i.e. the spread). Worse still people have an innate tendency to close out their winners (they see that they are making a quick buck) but then hold onto their losers. Hence you have people dumping their best ideas and paying financing (or borrowing costs) to hold onto their worst ideas (often ones where they are flat out wrong). Consider this example of a random demo account I made up for this article:

I would also argue that there are shades of grey - some things are more like gambling than others. If you have a look around the interface on a dealing platform you will often see some things which are clearly gambling. For example you will see things like 5 minute bets and we can safety say that no-one (especially not an honest retail trader) knows where the market is going in the next five minutes (they are not that inefficient). So in this case its totally gambling. Binaries are also offered by some providers and these things are just awful.

On the other hand, I am willing to accept that there are a tiny number of people who can successfully operate in this market (e.g. Simon Cawkwell). However, these are few and far between. These people tend to be very intelligent, have the correct psyche and are rich enough to tolerate huge paper losses (and sometimes huge realised losses).

Really, you have to treat spread betting a little bit like betting on horses (but with much more care). You have to realise that you are betting and also realise that you don't know everything. Spread betting can be enjoyable if done responsibly (which I say is £1 per point and below with rational stop losses) however it is essential to remember that you are speculating which is inherently risky. Whatever you do: don't delude yourself into thinking your investing, that you'll get rich or that your George Soros.

I think perhaps the most interesting question you could ask is: would Warren Buffett or George Soros make money in the long run (say a ten year period) if he was only allowed to spread bet? If you believe the answer is no then spread betting is 100% gambling and if you believe yes then it is less than, but perhaps close to, 100% gambling.