In the second of three articles on making money in a falling market, Dominic Coyle examines the rise of financial spread-betting - not a game for widows and orphans.
For those who live for the adrenalin rush of holding one's nerve against mounting odds, spread-betting is an increasingly popular fix. Among the variety of derivative products on the market, spread-betting is among those carrying the highest risk. The potential rewards are unlimited but so too can be the potential liabilities.
As one market source put it, this is not a game for widows and orphans. Unless you have a strong nerve and deep pockets, you have no business getting into this game. More importantly, unless you are a relatively experienced gambler - in the markets or otherwise - who knows when to cut their losses, spread-betting is ill-advised.
The biggest potential for losses is for those who, like lottery players, live in the fantasy world which tells them that sometime, their day will come.
The closest comparison is possibly the Lloyds insurance market.Like Lloyds - and indeed a number of other products among derivatives - there is no safety net. Insuring risks has made many Lloyds members very rich and, like the bull market, there were those who thought it would never end. It did and members - especially more recent entrants with more limited means - suddenly found themselves facing demands for money to cover underwriting losses that involved the sale of assets, home and family heirlooms. Some went bankrupt.
It is a salutary tale because big and all as the risk at Lloyds can be, the underwriting decisions are made by specialists. If people can still lose so badly, how would they fare with spread-betting where the individual investor relies only on their own expertise and the resources to which they have access?
Still for those with the sense and the appetite, spread-betting can be a tax-efficient way of accessing the markets. It is treated the same way as any other bookmaking enterprise and winnings are not taxed as income and not subject to capital gains in the same way that share ownership would involve. In addition, there is no stamp duty payable.
The one tax involved in spread-betting is the normal tax on betting and this tends to be taken on by the companies offering the odds and subsumed in the margin that features in the prices offered on individual indices, stocks, currencies and commodities.
The other main attraction of spread-betting is that it allows investors to make money in a falling market.
Financial spread-betting started life in the mid-1970s. It quickly became an amusement for City traders in Britain with time on their hands, easy money and a huge appetite for risk. Two things brought spread-betting out of the dealing rooms and into the more general investing population - the arrival of the smaller retail investor to the stock market and the end of the long-running bull market.
The first provided a market of people who had become familiar with the nature of the markets and the second gave them the urge to find other ways to make money. That coincided with the move of spread-betting online. IG Capital was the first to make the move and that was only in 1998.
Last year, the volume of trade in shares by private investors fell by around 30 per cent; at the same time, volumes in financial spread-betting grew by 25 per cent. More than 80 per cent of those involved are now private investors.
So, how does it work? The investor takes a punt on a particular index, currency, stock or other product available from the bookmaker. Say the FTSE 100 is trading at 4,030 and the punter thinks it is due a year-end rally. They ring the spread-betting operation to ask what spread it is offering on the FTSE for, say, December 2002. The range might be 4,050-4,065. If the investor thinks the index is likely to finish the year above 4,065, they "buy" - i.e. go for the top end of the range; if they think the figures too optimistic, they "sell" - i.e. go for the lower end of the range. In either case, they bet so much per point - say €20. They can opt to close either position before it falls due at end-December by opting for the contrary position at a later date (which happens if the market is going the wrong way for their original gamble) or they can hold their bet until it expires.
When the punter closes their position, the company calculates the difference between their opening bet and their new wager and multiplies that by the stake (€20) to calculate their loss. If the punter waits till expiry, the company works out the difference between the original target and the current FTSE 100 level and multiplies that by the stake to work out the profit or loss (see graphic).
The two things that accentuate the risk in spread-betting are gearing and margin calls. Gearing is a two-sided coin. On the upside, the nature of spread-betting is that each point above or below the target point is magnified by the amount that you have bet. For instance, if you bet €10 a point, each one cent movement in a particular stock or one point movement in an index will cost or win you €10. That allows for quick winnings but, equally, losses can mount fast.
Margin calls are also a feature of many derivative products. Basically, when you make a bet you either do so on credit or you lodge a sum of money with the spread-betting firm. Your initial stake will be a fraction of the overall bet. If the bet is going against you, your credit limit or deposit can disappear and the firm will ask you to make further payments to ensure you stay within the terms of your contract. Failure to do so can result in the company closing your position and holding you accountable for any losses incurred.
That can work against you if, for instance, the subject of your bet plunges sharply only to recover that ground later in the session or the longer term of your bet. If you fail to cover the margin, your bet may no longer be active by the time any recovery kicks in.
Of course, there are ways of limiting your losses. Many companies operate "stop-loss" devices. These do exactly as they suggest - they stop your losses. For instance, if you are betting on the price of an index - say the ISEQ Overall - it may be that you have predicted that it will continue to rally from its current levels of 4,240 to 4,500 at a rate of €10 a point. However, you can dictate a stop loss at 4,200 - limiting your loss on the deal to €3,000 - €10 a point for the 300 points shy of 4,500 at which the stop loss delimiter kicks in.
Two companies have entered the Irish market in recent weeks, bringing to three the numbers operating here. Until now, epan.com held the whip hand. It was the only operation based here and specifically targeting the Irish investor. Before its arrival, investors had generally been working through British-based spread-betting operations, adding currency risk to the underlying perils of the exercise.
Last month, a new Irish operation - delta index - opened shop, initially offering bets on the major indices and their leading stocks, where liquidity is highest. They also offered bets on the major currencies. This week, IG Capital joins the fray. One of the largest spread-betting groups in Britain, it has decided to set up a dedicated Irish operation to tap into the money salted away in the Celtic Tiger years and now looking for opportunities.
With the economy in a tailspin, it remains to be seen what appetite the tiger's cubs have for such high-stakes games.
