Advantages and Disadvantages of Financial Spread Trading

Easy to understand than other financial instruments - The process is less complex than that for options, futures and contracts for difference.

Tax free winnings - Tax is just another overhead and tax avoidance scheme/s are a welcome and widely accepted practice to increase profits. So eliminating it I have an immediate advantage over somebody that cannot avoid it. This is a key advantage of spread trading in that gains are free of tax (no capital gains or income taxes and no stamp duty). When using a traditional stockbroker, all profits are subject to Capital Gains tax. Moreover, spread trades are free from stamp duty, currently charged at 0.5% on all share purchases. This is because a spread trade is a contract tradeween the client and the spread trading company and no physical exchange of shares actually takes place. The only real tax due on spread trading is a 3% Trading tax charged on the firm's gross profits - which is absorbed by the company in the spread.

The savings do add up. For a purchase of GBP5000 of any share, the stamp duty charge paid to the Government is GBP25. A trader who deals twic a week, 52 weeks a year will end up paying GBP2,600 in stamp duties alone. If you were to trade GBP25,000 in normal share transactions each trading day via a stockbroker, you would pay the Government (brother Sam!) more than GBP31,500 in stamp duty over a year.

One of the biggest advantages as far as I'm concerned, is not just that no CGT or income tax is payable - but that I don't have to organize the tax-related records that comes with frequently buying/selling/reducing/increasing real shareholdings.

Potentially massive returns on low investments due to high leverage - Low margin requirements normally allow good leverage for larger positions. In most cases only tradeween 7.5% and 10% is required as margin to be deposited with the spread trading firm. This is called margin trading

Make phased exits without additional broker fees - One big advantage of using spreadtrades rather than actual share purchases, is that one can make phased exits without incurring duplicated or triplicated broker fees. This can have tremendous psychological value. I could for example determine beforehand that I will sell say one third on a 10% price fall, another third at 15% down, and only sell the remainder if the price is 20% down. (Or using 5%,10%,15% or whatever). I can thereby feel that I have been fair to that stock and given it every chance to rebound. Whereas with an actual shareholding the avoidance of multiple brokerage fees means setting a fixed level at which I sell the lot or don't - and that "all or nothing" moment is where many investors get stressed and come unstuck by feeling they really ought to give it "one more day" or whatever, only to then find themselves tipped into a sharp fall that is triggered by other market participants who did sell. There are occasions where I will phase my way into or out of a particular trade in £1pp increments. (£1 per point is the equivalent of buying or selling 100 shares, which is too small an increment to be viable if repeatedly applied to a real shareholding).

It is commission-free - All the costs associated with spread trading are built into the bid-offer spread.

Possible tax savings - For example, if you own a share paying a dividend, income from that dividend is taxable at your current income tax rate. Spread trades do not pay dividends. Instead, the dividend payment is build into the bid-offer spread so the holder of a position in a dividend-paying share will reap the rewards in the form of a tax-free capital gain rather than taxable income.

The ability to trade in amounts less than the standard market contract sizes - With some you even trade with just 1p a point via the Internet.

The ability to trade outside market hours - Most spread trading companies are open 24 hrs a day from Sunday night until Friday night. i.e. in many cases it is possible to deal when the traditional markets are closed. Contrast this with normal market trading hours which run from 8.00 am to 4.30 pm !

Controlled risk trades - A controlled risk trade is one which has a special kind of stop-loss order attached to it. When you open a controlled risk trade you pay a small premium though an increase in the bookmaker's dealing spread, and you choose a stop loss level at which if the bookmaker's quotation reaches it, your trade is to be automatically closed out.

No huge capital outlay required - You can start to trade with as little as £100 on deposit and use as little as 1p to "trade" on the price movement of shares, market indices (such as the FTSE, NASDAQ, Wall Street (Dow Jones), S&P, Nikkei), currencies or commodities (such as gold or oil) Also, there is no different spread quoted for a smaller size trade. Therefore small positions are not penalised like they can be in cash markets.

Credit facilities - Subject to your experience and financial status most spread trading firms will offer you a credit account which eliminates the need to tie up capital.

Immediate dealing - Executions are completed within 1 minute. This is because spread trading companies are not brokers, so all trades are contracts tradeween the client and the spread trading company. Thereby each execution is not necessarily traded over an exchange and there is no delay in routing the order.

No currency risk - Dealing in foreign share can be cumbersome and impractical if you are an average investor. You have to deal with a third party and pay transaction charges. For example, in 2002, traders found it strenous to balance their books in sterling terms because of the ups and downs of the yen and the US dollar. Spread Trading allows traders to trade in pounds per point on international shares.

Wide range of markets you can trade on - Herein lies one of the main benefits of spread trading. They deal on most exchange traded contracts that are liquid as well as some not so liquid ones/less accessible ones like Polish Index, (ATX) Austrian Index, (Bel20) Belgian Index, (OMX30) Swedish Index, taiex, zinc, lead , tin, aluminium, carbon emissions, london housing, currencies, options, interest rates, commodities, football (!), horse racing (!), rugby (!) to how many sips of water the Chancellor Gordon Brown is going to drink during his Budget speech!! Being able to trade on indices is a great advantage because in my opinion it is far easier to see if the tide is going up or down rathering than looking at lots of different boats to put your money into. Most make markets for trades on stocks, stock options and future options as well from major exchanges. trades are available on many liquid assets including a wide range of quoted shares, and at some spread trading companies this extends down to companies with a market capitalization as small as £10m.

Ability to go short or long (i.e. you can make money when markets rise or fall) - Shorting allows you to make money not only in rising markets but also in falling markets. With stock markets so bearish over the last two years, it has been extremely difficult to make profits as a trader without the ability to go short.

Diversification - The only thing free in investment is diversification. Not exactly true but quite close. By allowing you to trade on an index rather than just a share, you can gain instant balanced explosure to the market.

You don't need to own assets in order to profit from them

Trade many different markets from just one account - Spread Trading provides people with the ability to trade many different markets from just one account - British shares, American shares, European shares, stock market indices, government bonds, exchange rates, gold, oil, index options, and of course sport and politics.

You can Limit your Losses by placing 'Stops' on your Account

Less paperwork is involved compared to conventional share dealing. - setting up a spread trading account is simple and quick, all that is required in most cases is a signed application and utility bill

Spread Trading makes it easier to track your investments - if share X is up 15 points on the day, it is far easier to estimate your profit by calculating that you have made a GBP10 per point increase than calculating your number of shares, say 12,500 multiplied by 15 points, less broker charges, stamp duty, tax and so on...

Online trading platforms for spread trading are often said to be more advanced compared to those to traditional share dealing.

Virtual trading platform are sometimes available - some spread trading companies offer a virtual trading platform for you to practice on. This offers an opportunity for potential spread tradetors to understand the market, the dealing process and test trading strategies before committing real money. The ability to practice with virtual money helps reduce the risk of entering into incorrect postions and helps novices to understand the risk involved in dealing with geared products.

Innovation and flexibility ( binary trading comes to mind) - Another major advantage that the spread trading companies have over the more traditional firms in the financial markets is that they can offer new products or variations on established products very quickly. Because their products are so called Over-The-Counter (OTC) they don't have to go through the regularity process that major Exchanges do. All financial spread trading companies are however fully regulated by the Financial Services Authority (FSA).

There are pros and cons to spread trading, Profits are not taxable. However, in spread trading you can lose more than your initial capital. The industry is continaully changing shape to appeal to a wider market.

Disadvantages of Financial Spread Trading

Danger of being careless and trading too large a size for your finances.

A disadvantage of spread trades is that the bookmaker's spread tends to be slightly wider than commission one might pay to a stockbroker - This partly reflects the gross profits tax which bookmakers pay of 3% of gross profits.

An important disadvantage is that the funding cost (typically at around LIBOR +1-2%) is charged on the entire position (usually this applies even where the client has been required to deposit some funds as margin with the bookmaker) - I suspect that a large part of the bookmakers' income is attributable to the funding charges. For long positions held for more than a few weeks, the cost of funding tends to outweigh saving on stamp duty (although if the investor wants leverage, a spread trade is still probably cheaper than most alternatives).

You can lose more than your initial deposit or capital. - The margin trading involved means that while potential profits are magnified, potential losses are also magnified, except for trades with stop losses. With ordinary share trading, you cannot lose more than the amount you invested in the shares. There is no such limit with spread trading.

The FSA considers spread trading as a gambling activity - This in itself has its pros and cons...if you tell your wife that you're trading she's more likely to be understandable ;) However, also keep in mind that winnings are free of tax for a reason - the FSA believes that more people will LOSE than WIN...so you'd tradeter be smart aisle

Many spread-trading markets are very volatile - Unless you place a 'guaranteed stop-loss' you can suffer very large losses if the predictions go against you.

Spread trade winnings are not taxable, and correspondingly there is no relief for losses.

The investor does not own the instrument they trade - This means that he does not receive any of the benefits he might expect with share ownership, such as dividends. Of course, you get the benefit of the dividend through the bid-offer spread...

Spread trades have a specified lifetime and cannot be carried over after their expiry date - So the investor cannot hang on hoping for a long run improvement. The only way to continue trading the same instrument is to close the current trade and open a new one. With conventional share dealing, you crystallise your loss only when you sell the shares (no expiry date)

Trading costs in spread trading increase over time - For short term positions held for a few weeks or months, spread trading costs are very competitive compared to ordinary share trading but if you want to hold the position for more than six months, or become a long term investor, it is cheaper to buy the shares in the conventional way. This is because costs are incurred each time a spread trade is 'rolled' over or extended to a new expiry date (all spread trades have a definite expiry date) If you wish to run your trade beyone the expiry date you must roll your position over from one quarter to the next.

The spread is different to the cash market spread - you have to factor a certain increase or decrease in the price before you are in profit (due to the evil bid-offer spread...).

It is difficult to make money in the long term from short selling - The general drift of share prices is upwards; and a short position which goes against the investor can quickly become a very large problem. If you understand the perils of excessive leverage and can avoid the temptations in practice, a spread trade may be the most cost-effective way of taking a short-term position.

The real enemy of spread tradeters is the kind of range-bound market we saw for much of the earlier part of say 2002. - If you have the FTSE 100 index closing at 5,262 every day for weeks, as it appeared to at the beginning of 2002, it can be a remarkable disincentive to trade. On the other hand spread tradeters thrive in periods of volatility. When the Dow Jones moves 750 points in a day, first by opening 200 points down and then moving more than 500 up, that's a real opportunity to make money for a sophisticated investor.

Remember : With spread trading there are real charges: They exist in the spread

Spread Trading agencies tend to promote their service on the basis that one of the advantages of using this method of investing is in the fact that they do not have transaction charges or fees. This is simply not true - the transaction charge is firmly embedded in the spread. If you are serious about spread trading then you have some homework to do, and the very first place you must start is in an analysis of spreads offered by different spread trading agencies. Currently Capitalspreads.com and Deal4free.com seem to have some of the tightest spreads around.

This article was originally  published on http://www.financial-spread-betting.com/  a UK financial website which  specialises in offering free guides and information on stockmarket products  such as financial spread trading.