Spread Betting in Forex Explained: A Complete Guide
On the 15th of January 2015, the Swiss Central Bank pronounced that the Swiss Franc would no longer be pegged to the euro. What happened next offers a real-life understanding of spread betting in forex. On the one hand, traders who had bet against the Swiss franc experienced losses while those who had bet on the euro or dollar reaped big. This is because the Swiss franc gained value against both the dollar and euro shortly after the announcement.
With that basic overview, we can now explore what is spread betting in forex and how it works.
What is Spread Betting in Forex?
What is Spread Betting?
Generally, spread betting is a strategy that allows traders to take bets or to speculate on the price movement of security such as stock, currency pair, and commodities. Unlike other trading strategies that require the investor to own particular security, spread betting does not. This makes it is a derivative strategy.
Spread betting, as a concept, borrows part of its definition and operating principle from the trading term ‘spread.’ In financial trading, a spread relates to the difference between the buy and sell prices of an asset or the variance between the bid and ask prices. It is no surprise then that spread betting involves the difference between two prices, but with a speculative twist.
In addition to representing the differences between two prices, the spread also influences traders’ preferences. This is especially so because traders fancy currency pairs with low spreads. Notably, low spreads indicate low currency volatility and high liquidity, with the latter determining the ease with which a trader can enter or exit a trade. Moreover, a low spread is associated with low transaction costs.
Ordinarily, major currency pairs have low spreads, while emerging market currency pairs have high spreads. As a result, forex traders prefer dealing in major currency pairs.
Spread Betting vs. Spread Trading
It is also worth noting that spread betting does not equate to spread trading. Spread trading is when a trader purchases one security and sells another related security simultaneously as a unit. Traders and investors undertake spread trading to yield an overall net position – arrived at by finding the difference between the buying and selling price – whose value (spread) is positive.
The most common securities exchanged in spread trading are options and futures, although others can occasionally be used.
Spread Betting vs. Contracts for Difference (CFD)
While it is a derivative strategy, spread betting should not be confused with contracts for difference (CFD). CFD is a common trading approach in the financial world of forex and commodities, especially in countries where it is allowed.
Like spread betting, CFD is a derivative that enables the trader to speculate on financial markets. It involves a broker and investor. A CFD trader who expects an uptrend in the price of a security will buy a CFD. On the other hand, a trader who has bet on a price drop sells an opening position.
If the prices increase, the buyer offers to sell their holdings. Then, the difference between the buying and selling prices is calculated, representing either a profit or loss. If there is a loss, the trader pays the broker. But if there is a profit, the broker will settle the difference by paying the trader.
If the prices drop, the buyer, who had placed an opening sell position, purchases the security in what is referred to as an offsetting trade. The difference between the selling and buying prices is computed, with the broker or trader footing the bill accordingly. That said, what is spread betting in forex?
Forex Spread Betting
Forex spread betting is a category of spread betting that, as the name suggests, involves speculating on the price movements of currencies in the foreign exchange market. It refers to an approach wherein a trader bets on whether the value of one currency in a currency pair will increase or decrease relative to the second currency. However, the trader does not (and cannot) own any of the underlying currencies.
Spread betting on forex is carried out on brokerage sites operated by brokers who quote the bid and ask price. In forex, the difference between the bid and ask prices constitutes the spread, expressed in pips.
To bet on a currency pair’s price movement, a trader simply opens a buy/long position – in cases where they expect the value to increase – or a sell/short position – when they anticipate a dip in value. Whenever they expect the price will drop, the reference figure is usually the bid price. Similarly, in cases where they anticipate a price rise, the reference figure is the ask price.
In summary, forex spread betting takes three primary attributes into account. These include the anticipated direction of price movement, the spread of the currency pair, and the amount wagered.
Usually, the trader is at liberty to choose the amount of money to wager in order to either maximize the expected gains or limit the loss potential. At the same time, spread betting in forex applies the concept of leverage.
For instance, with a 100:1 leverage ratio, a trader only needs to deposit $100, which then offers increased exposure to a position valued at $10,000. The leverage amplifies the profits or losses, meaning a trader can lose or gain more money than their initial investment.
How Does Spread Betting in Forex Work?
|Currency Pair||Quote Price||Designation|
|GBP/USD||1.3705/1.3708||GBP is the base currency|
|USD is the quote currency|
|1.3705 is the bid price|
|1.3708 is the ask price|
Trader A wishes to trade in the GBP/USD currency pair using a trading account domiciled at a brokerage firm that has quoted 1.3705/1.3708. In this case, 1.3705 represents the bid price, while 1.3708 represents the ask price. As well, the spread, which is the difference between the bid and ask prices, is 3 pips.
If A is of the opinion that the pound sterling will strengthen against the dollar, they could bet £5 for every pip above the ask price (1.3708). If after some time the value indeed grows to 1.3719, the brokerage firm would credit A’s account with £55 (£5*11pips). In the event that they had leveraged their bet with a 50:1 ratio, they would receive £2,750. However, if the value drops to 1.3697, A would lose £55 (if unleveraged) or £2,750 (if leveraged).
On the other hand, if the trader expects the value of the pound sterling will drop relative to the dollar, they could bet £5 for every pip below the bid price (1.3705). If the value indeed drops by 12 pips, A would earn £60 in profits (if unleveraged) or £6,000 (with a 100:1 leverage ratio). However, if the value increases by 12 pips above the bid price, A would lose £60 if unleveraged or £6,000 if leveraged.
Forex Spread Betting Strategies
While spread betting in forex may be a speculative approach to earning returns from the forex market, it could still greatly benefit from strategies that guide the speculation. Some of these strategies include:
- Trend following
- Forex scalping
- Forex hedging
- Momentum trading
- Breakout trading
- News trading
Trend following is a trading strategy that aims to maximize gains by analyzing the currency pair’s price momentum in a given direction, whether up or down. Traders analyze the trend using forex trend indicators, which help eliminate the reliance on gut feeling.
This strategy capitalizes on slight price movements to make a profit. Conducted by scalpers, the forex scalping strategy involves buying a currency and subsequently selling it after a few seconds or minutes. It takes advantage of price variations, common throughout a trading day.
Forex hedging is a risk mitigation approach that involves taking multiple positions. It helps cap traders’ losses by acting as some sort of insurance policy against the price fluctuations within the forex market. And as we detailed in the example above – the pronouncement by the Swiss Central Bank – this market can be impacted by adverse conditions, multiple at that.
Momentum trading in forex refers to a strategy wherein traders buy currency pairs whose price is increasing. They then sell them once they appear to have peaked.
The breakout trading strategy takes advantage of a concept known as a breakout. At its core, a breakout refers to the price movement beyond a level that the security has previously been unable to surpass. In this regard, a breakout trader buys a currency pair whose price has stagnated at a particular level. They subsequently sell once it moves beyond this point, whether upwards or downwards.
In forex spread betting, the trader will bet that the price will increase or decrease beyond this level.
The value of a currency pair fluctuates based on a number of factors. These include the prevailing interest rates, inflation rates, and government policies and declarations, to name a few.
Thus, the news trading strategy aims to capitalize on the anticipated price movements as a result of these factors, which news outlets usually report on. Simply, a forex trader using the news trading strategy monitors the news for hints that could influence the price movement of one or more currency pairs.
Risk Mitigation in Forex Spread Trading
As detailed, spread trading in forex could result in profit or loss. Moreover, when a trader leverages their position, the magnitude of the gain or loss is amplified even further. At the same time, sudden price movements as a result of unexpected government declarations, such as the Swiss example, increase the risk associated with the position, which could be greater than the trader’s initial quantified risk potential.
In this regard, it is paramount that you reduce the chances of making losses by implementing various risk mitigation strategies. These include:
- Stop-loss orders
- Forex arbitrage
This risk mitigation approach closes out a losing bet once the prices pass a certain defined level. For instance, you can stipulate that the trade closes out once the prices increase (if you had bet against currency) or decrease (if you had bet on a currency) by 5 pips. In doing so, you will limit your losses to, say, $50 if you had bet $10 for every pip.
A trader employing the forex arbitrage strategy aims to capitalize on price inefficiencies or interest rate differentials. Notably, this analysis will focus on the latter (price fluctuations). Here, you can bet two ways – the first using broker A and the second using broker B – as a way of spreading the risk. Given that each broker will quote a different price, it enables you to reduce your exposure to losses. One broker’s spread is bound to be smaller than the other’s.
Spread betting in forex offers an avenue of making profits without owning a currency pair. It is a speculative approach that traders can use in concert with various forex trading strategies to increase efficiency and maximize gains. However, it is crucial to keep in mind that forex spread betting has a risk component. You could lose money as easily as you can profit. It is, therefore, important to mitigate against the risk by employing risk mitigation strategies.