Leverage in Financial Spread Betting - How It Works
You can't delve very deeply into spread betting without hearing constant reference to leverage, and for good reason. Leverage is one of the most considerable factors in the spread betting concept, and a core part of what makes it a popular trading method (in addition to its favourable taxation treatment). Without leverage, which represents the core of spread betting as a trading instrument, the opportunities for profiting from incremental ticks in the market would be significantly less frequent, and the spread betting proposition altogether less attractive.
Leverage, also known as gearing, is best described as an artificial amplification of a trading transaction size in order to deliver stronger returns on a given spread bet. In share dealing, for example, you may be able to arrange to cover 5% of a transaction’s total size with your own capital, with the remainder being funded by the broker on a short-term casual financing arrangement, thus allowing you to profit from market movements on the total transaction size rather than on a straight transaction for the same amount.
For example, let’s assume you have trading capital of £5. With leverage, you can notionally increase your trading capital to £100 for a particular transaction. When the market moves up 10%, your account will rise to £110, at which point the leverage portion is paid back to the broker. This leaves you with £110 – £95 = £15 in profit – a 300% return on your capital. As this example expresses, leverage can be a significant earner, and helps make the most of winning positions when they arise.
The leverage component of spread betting works in a slightly different way, and can take place on two separate levels. Firstly, leverage is built in to the spread betting transaction in the sense that minor movements are automatically geared up to deliver larger returns. Unlike most forms of leverage, which comes as a result of borrowed finance (and attract an additional cost as a result), the inherent leverage in spread betting arises by virtue of the fact that a one point movement returns 100% of the original wager. This effectively means that the automatic gearing in-built into spread betting is 100:1 – i.e. a one percentage point movement delivers one hundred percent return on capital. So, if a position moves up 5 points, that’s 5 times your stake in return.
Of course, the same is also true in reverse, with a one point decline leading to a 100% loss, and so on. It is this leveraging effect that makes spread betting instantaneously both highly profitable and highly risky for investors.
The second element of leverage in spread betting transactions that can come into play is leverage in the more traditional sense – that’s leverage that is fronted by the broker and then paid for by the trader in the form of financing costs. The impact of this kind of leverage is to artificially bolster the transaction size – so, instead of trading at 10p a point, you might be able to trade at £10 a point. This form of leverage is arguably even more risky than that built in to the DNA of spread betting as a transaction, given that the leveraged portion has to be paid back and accounted for with interest.
The overall impact of leverage is to speed up the trading cycle, and to maximise both profits and losses through trading with larger proportionate stakes. As such, leverage can be seen as the classic double-edged sword – on the one hand, it can deliver wild returns in a matter of minutes that would simply be unattainable in more traditional markets, while on the other it can rip the rug from underneath your feet and cost you your trading livelihood in no time at all, as a result of one or two bad decisions.