In this article we look at 3 of the key benefits of financial spread betting over direct equity investment. We look carefully at the downsides of each.
1. Gearing up means bigger profits!
You will often hear that financial spread betting allows us to ‘gear up’, that we get ‘more leverage’ and improve ‘multiples’. But what does this really mean? The simple fact is that most people only have so much capital Google TV to speculate with. Let’s be honest, you should never spread bet with money you can’t afford to lose (my golden rules 1, 2 & 3!). So let’s take Average Joe, who has managed to get around £1,000 of disposable income together and has done some research on Target Company Ltd (TCL) and thinks their share price could well go up over the next week, for reasons that he’s not about to share with me and you. TCL currently has a mid price of 50p, and Average Joe is hoping the share price will rise 20% to 60p.
Joe’s option number one is to purchase 2,000 shares through a stockbroker. Based on a mid price of 50p, the actual buy price was 51p and the sell price 49p. So Joe’s 2,000 shares cost him £1,020, plus he had stamp duty of 0.5% (£5.10) and stockbroker commission of £10, taking his final investment cost to £1,035.10. A week later the share mid price has indeed risen to 60p, being buy 61p and sell 59p. Joe sells his 2.000 shares, grossing £1,180, leaving him with £1,170 after his £10 stockbroker commission. Net profit for Average Joe on this transaction is therefore £134.90.
So what about the ‘leveraged’ choice? Well, Joe’s second option is to place a spread bet on the TCL share price, which would typically be quoted by spread betting companies at 49-51. At £200 per point, Joe will require a 10% deposit, amounting to his disposable £1,000. He will ‘buy’ (as he expects the share price to rise) at 51p on a rolling bet. A week later, when the stock reaches 60p, the price will likely be quoted 59-61p by most spread betting firms. He then ‘sells’ out of his open trade at 59p, recording an impressive gross profit of £1,600. There are no commission charges or stamp duty payable, so the only deduction would be a small financing charge of approximately £10, leaving net profit of £1,590.
So what’s the downside? Well, gearing up your wins also potentially gears up your losses. It would be vital for Joe to get a ‘stop loss’ at 46p, so that if the price fell it would limit his overall loss to the £1,000 disposable income he has.
2. No Taxes
Hard to believe, but absolutely true. UK legislation has long exempted gambling winnings from the tax charge, and as spread bets are legally gambling, all wins fall outside the charge to tax.
So, assuming Average Joe has used up his CGT allowance in the year, and is a higher rate tax payer, he would pay 40% tax on his £134.90, amounting to £53.96, leaving him just £80.94. In contrast, the £1,590 profit from the spread bet would remain untouched.
So what’s the downside here? Whilst this may make the UK tax authorities sound very generous, the underlying reason is easy to understand if you take it in context. To bring gambling ‘winnings’ into the charge for tax, would require gambling ‘losses’ to be allowable tax deductions, something the authorities were not keen on! So you should remember that losses on spread bets can not be used against profits you make elsewhere. Secondly, the first £10,000 of capital gains each year are tax free in any event, so the tax free benefit only arises on amounts over that. Finally, Capital Gains are taxed at the individuals highest rate of tax. So the 40% cost noted above only applies at the highest levels of income.
3. No FX issues
This is one of the benefits of spread betting that rarely get discussed and, unlike the first two points, doesn’t have a real downside. Let’s leave aside currency risk for a moment, and look simply at transaction costs. You know how it is when you go on holiday and have to convert sterling into the currency of your destination. When you come home with what’s left and change it back into sterling, the rate is never the same, is it? As with share prices, currencies are always quoted with a ‘buy’ and a ‘sell’ price, which is how the person translating that currency for you makes their money. Likewise, the stock broking companies understandably take a margin for having to translate into a foreign currency and back from that currency into sterling whenever you want to buy and sell a foreign stock. In our example above, Average Joe purchased a UK stock, so he wasn’t impacted. But imagine the share was a US stock, such as Microsoft. He would have paid perhaps 1.5% margin to get into US Dollars for the purchase (£15.30) and then another 1.5% margin to translate his sales proceeds back to Sterling (£17.70). These additional costs of £33.00 take a considerable chunk out of his original £134.90 profit.