Spread betting is an inherently risky enterprise. The huge opportunities for profits that spread betting offers only comes with a commensurate level of risk.
A large part of the inherent risk comes from the fact that spread betting is a highly leveraged investment product (meaning that it amplifies profits greatly but can also expose bettors to potential large losses).
Therefore, in order to be a successful spread bettor, it is critical that you practice good risk management in your trading. This article covers the basic risk management principles, as well as risk management tools – trading tools – that spread betting companies make available to you.
The Risks of Spread Betting
The first step in managing your spread betting risk is understanding clearly what the risks of spread betting are. Here’s a rundown on the inherent risks associated with financial spread betting:
- Leverage – Leverage is a great trading tool that enables small investors to make significant profits trading the financial markets. But leverage can work against you just as easily as it can work for you. Highly leveraged trades carry the possibility of incurring losses that exceed your deposits.
- Unexpected Economic Events – In an increasingly global economy, unexpected economic news, even from thousands of miles away, can create sudden volatility and trigger massive market price movements within just a matter of minutes – or even seconds. A sudden interest rate change, a mining strike, a change in political power – these and other events can have a huge and immediate impact on one or more of your spread bets.
- Market Gaps – Trading gaps – where a security such as a stock opens much higher or lower than its closing price from the previous trading day – happen frequently in the financial markets. If you hold spread bets overnight, you must be aware of the increased risk this poses to your trading position(s). Trading gaps are particularly common in stock trading.
Basic Principles of Spread Betting Risk Management
There are certain basic principles to follow for effective risk management, in addition to specific spread betting tools for managing risk that are provided through your betting firm’s trading platform.
Know the Market(s) you Bet – Every financial market is different. Stock shares don’t trade the same way that commodities do, and commodities don’t trade the same way as the forex currency exchange market. Becoming familiar with the market you want to spread bet before ever deciding to trade is the first step to good risk management.
Learn the times of day when your market tends to be most active – when significant price changes are likely to occur. Know the average daily trading range of any financial instrument you trade. And of course, make sure you know the minimum price movements and what kind of profit/loss each point represents.
Understand Pertinent Economic Data – Learn which economic reports are most likely to significantly impact the instruments or markets you trade. Generally speaking, the most important (high risk) economic reports to watch are the following:
- Gross Domestic Product (GDP)
- Employment/Unemployment Figures
- Retail Sales
- Producer Price Index (PPI)
- Consumer Price Index (CPI)
If you’re spread betting individual stocks, keep track of when the company releases quarterly and annual earnings reports. Earnings reports – especially when they come out significantly higher or lower than expected – are major movers of stock prices and may determine the overall price trend for some time (at least until the next earnings report).
For the convenience of their clients, spread betting firms publish a daily economic calendar showing all the data releases scheduled for that day.
Have a Definite Trading Strategy
Financial spread betting is not meant to be blind gambling. It’s a form of investing. Your spread bets should always be based on careful market analysis – fundamental analysis, technical analysis, or some combination of the two. Part of your market analysis should include calculating the risk/reward ratio for any spread bet you’re considering:
What’s your reasonable potential loss vs. your reasonable potential profit?
Your maximum potential loss is 18 points and your potential gain is 42 points. That’s a favourable risk/reward ratio because the potential profit Is more than twice the potential loss.
On the other hand, if the highest price you could reasonably expect the stock to reach was 105, then the bet would not be attractive from a risk/reward analysis, as you’d be risking 18 points against a potential gain of only seven points.
Whatever your trading strategy is, it’s critical that you exercise the necessary self-discipline to follow it, to abide by its rules, even during times when it’s not performing well.
Many studies have found that “not following your trading strategy” is a much more common cause of losing trades than “using a flawed trading strategy”. A good trading strategy has clear rules for entry and exit, employs stop-loss orders to minimise risk, and is well-suited to the market you’re trading.
Understand Leverage and Margin Requirements
Because spread bets and CFD (contracts for difference) trading offer extremely high leverage, it’s essential to understand how leverage and margin requirements work.
Know the amount of leverage that you’re betting with, because that enables you to calculate the value of each point in your bet. The margin requirement for a spread bet is the amount of money you have to put up to initiate and hold your spread bet position. Use bet sizes that match up with the amount of trading capital you have.
Make sure you always have enough money in your account to cover the required margin for your spread bet(s) – and don’t forget to allow for the market to temporarily move against you, which will increase the margin required to hold the position.
If you lack the necessary margin money, your spread betting firm will automatically close out your bet. This may result in you losing money when – had you been able to maintain the position – you would have ended up with a winning bet.
Specific Risk Management Tools for Spread Betting
Spread betting companies offer their clients several tools to help them limit and manage risk.
1 – Stop Loss Orders
Stop loss orders are one of the most basic risk management tools. A stop loss order is designed to help keep any trading losses at an acceptably low level. Keeping your losses small and manageable is key to being overall profitable in your spread betting enterprise.
Here’s how a stop loss order works:
Assume that you place a buy spread bet with the spread at 70-72, perhaps based on that price level being one of the daily pivot points where price may find support.
Now assume that technical analysis indicates that if you are correct in your price forecast, then the price should not drop back below 60. If the price does decline to below 60, then that would indicate that your market analysis is probably incorrect, so you wouldn’t want to hold your bet and risk further loss. You handle this situation by placing a stop loss order at 58.
If the bid price – the first, lower number quoted in the spread – drops to 58 or lower, then your stop loss order is triggered, and your bet automatically closed out at the best available market price.
Note that, when triggered, a stop loss order effectively becomes a market order. Therefore, unlike a limit order, it is not guaranteed to be filled at a specific price – only at the best available market price at that time.
You can further manage risk by adjusting your stop loss price when the market moves in your favour. You can move your stop loss price to a level that further reduces your risk – or if the market has moved substantially in your favour, you can move your stop loss to lock in some profit.
2 – Guaranteed Stop Loss Orders
By paying a slight premium, you can get a guarantee that your stop loss order will be filled at exactly your specified stop price. This is true even if the market gaps past your stop price level from the market close on one day to the market open the next.
3 – Limit orders
Limit orders are only filled if they can be filled at the price that you specify, or better. Limit orders can be used to manage your risk by making sure you take profits when possible.
The way to avoid this scenario is to place a limit order to close out your spread bet at 75. When the market, even just momentarily, traded as high as 80, the limit order closing out your bet for a hefty 25-point profit would have been filled.
4 – Using Hedging to Manage Risk
Hedging is another popular risk management tool. Hedging your market position is a way of protecting your profits in an existing trade. It is accomplished by taking an additional market position that is likely to rise in price if your existing market position declines.
Hedging works by using two bets on securities that have an “inverse correlation”. An inverse (or negative) correlation simply means that, historically, the prices of the two securities have typically moved in opposite directions. An example of such an inverse correlation is the relationship between the stock market and basic commodities.
5 – Portfolio Diversification
Of course, you can elect to keep both bets in place indefinitely. Choosing that course of action is another means of protection against risk – not by hedging, but simply by means of diversification. By betting on a variety of financial instruments, you may not succeed in absolutely maximising your potential profit, but you will obtain significant additional protection against losses.
This is because having a diversified portfolio of investments usually means that when some of your spread bets are losing money, others are showing profits.
There is an inherent level of risk in spread betting, so it may not be suitable for everyone. Whether it’s right for you will depend on your risk tolerance and investment objectives.
Fortunately, spread betting companies offer several risk management tools to help you trade more profitably. You can use trading tools such as limit orders and guaranteed stop loss orders to either lock in profits or protect yourself against unacceptably large losses.
You should only spread bet with money that you can afford to lose. Before deciding to trade, make sure that you understand the risks, the market you plan to trade, and how to use the various risk management tools offered by your spread betting provider.
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CHAPTER QUICK LINKS
- 2.Why Spread Bet
- 3.Who Should Spread Bet?
- 4.How Does Spread Betting Work
- 5.History of Spread Betting
- 6.Markets You Can Spread Bet
- 7.Types of Spread Bet
- 9.Sports Spread Betting
- 10.Spread Betting Regulation
- 11.How Spread Bets are Priced
- 12.Spread Betting Examples
- 13.Spread Betting Strategies
- 14.Make a Living
- 15.Spread Bettor Mistakes
- 16.Risks of Spread Betting
- 17.Beginners Recommendations
- 18.Next Steps