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Investing and Economics Blog

Spread Betting and Contracts for Difference

I am largely a fundamental investor with the long term time horizon that fits such investing. I however am also a believer in using some more speculative investing for a portion of a portfolio if it fits the risk profile of an investor.

If you are not comfortable with the risk of an investment most of the time you shouldn’t make that investment. There is a bit of a conflict, for example, where an investor is scared of any loss from say an investment in a stock market index and trying to save for retirement on a median level income. It is nearly impossible to save for retirement without investing in stocks if you are not already rich, so as with most investment advice there is a bit of difficulty at the extremes but in general investors shouldn’t take on risk they are not comfortable with.

For experienced investors with a high level of financial literacy more speculative options can have a useful role in a portfolio. Though you should realize most people fail with speculation, so you have to be realistic about your prospects. I have used speculative investments including naked short selling, leverage (margin) and options.

Spread betting is another speculative strategy that can play a part in an investment portfolio. Spread betting is not allowed in the USA (with our highly regulated personal investing environment but is available in most other countries). They are somewhat similar to binary options (which are allowed in the USA) and to futures contracts (they are not the same, just those are comparable to get some idea of how you would use them in a portfolio).

Spread betting really is a bet on what will happen. You don’t buy a financial instrument. You place a bet with a company and if the prices move for you and you close the position with a gain they pay out a gain to you and if you close out the position with a loss your capital held with them is reduced by your loss amount.

Since the price to control a position is much less than the notional position size there is a large degree of leverage which increases the affect of gains and loses. Since positions can move against you and must be settled if the loss exceed your deposit with the company you are trading with having a substantial cash cushion is the way I would use such a speculative account. If I decided I could afford to risk losing $5,000 I would deposit that amount.

My purchases would about 10% of the capital in the account (so $500 at first). If that is leveraged at 20 to 1 (just requiring 5% down on margin), that would make my effective leverage just 2 to 1. But if I added other positions that would increase my leverage, say 2 more purchases and my leverage would be 6 to 1.

The way I have managed the speculative portion of my portfolio is to fund it and then pull off part of the gains to my long term portfolio and retain part of the gains to build my speculative account. It isn’t really quite that clear as I have different level of speculation in my portfolio. Options are speculative but have a limit of 100% loss. Selling stocks short (naked shorting) is speculative but has theoretically unlimited losses. Using margin on regular stocks has the potential to lose more than you have invested though most of the time you should be stopped out before the losses are too much beyond your entire account value.

So I don’t really have a clear cut speculative portfolio but I roughly follow that procedure. I have added to the speculative portion when I have had very large gains in a particular portion of my main portfolio.

Another factor with spread betting, shorting and options is that they can actually be used to reduce the risk of your overall portfolio using certain strategies. If you believe there is a risk for a market downturn but don’t want to sell any of your stock holdings you can use spread betting to create a position that will gain if the market declines. That gain then will offset the likely loss on your stock positions thus reducing you risk in a market decline.

Of course, if you do that and the market moves up you will create a loss on you spread betting position that offsets your gains on your stock positions. You could also bet against specific stocks that you think will decline more in a market decline and seek to increase your return of course that has risks (including the market declining along with your stocks but that stocks you bet against could move against you anyway). I have used this strategy with selling stocks short occasionally.

An additional risk to consider with spread betting is you need to find a company you trust to be around to pay off your gains. You would want to examine the safety of your funds and that (in the UK) the account is covered by the Financial Conduct Authority (FCA) and complies with the FCA’s Client Assets provisions (and in other countries they have similar coverage). To be safe you should consider whether holding more than the covered amount is wise in your account. The last 10 years have provided examples of the riskiness of financial companies going out of business; that your funds wouldn’t be accessible is a risk that must be considered.

Related: Shorting Using Inverse Funds – Books on Trading and Speculating in Financial Markets – Selling Covered Call Options

January 20th, 2015 John Hunter | Leave a Comment | Tags: Financial Literacy

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