How the Spreads are Calculated

Betting companies will often be heard talking about their 'tighter spreads', which simply amounts to lower charges. Bid-offer spreads are familiar to anyone who trades shares, but unlike traditional share dealing there are no associated costs involved such as stamp duty, broker commission and administration fees. With spread betting, all the fees and trading costs are wrapped inside the spread, so calculating your profit or loss on a deal is straightforward.

Bid-offer spreads are calculated in different ways, but the starting point is the underlying market future price. The quote will reflect the 'cost of carry' - the financing cost of the trade to its expiry date - and any dividend payments before expiry.

Spreads change all the time, sometimes quickly and sometimes slowly, depending on what's happening in the underlying market. Once they have gained experience, spread betters may want to open more than one account to compare spreads and pick the best deal for a particular trade.

One thing that sometimes causes confusion among newcomers to spread betting is the relationship between the spread bet price and the underlying price of the asset in question, whether it is a share, a stock index or a commodity such as oil.

The two variables that define a spread bet are the underlying instrument and the time frame, since taken together these determine how the bet will settle if held to expiry. The time element means that if betting on a stock index future, the midpoint of the spread will not normally be the same as the current cash market price from the LSE.

When spreads are quoted at a premium to the underlying, this reflects the sacrifice of interest that a trader experiences through buying the actual shares for cash rather than taking what is in essence a forward position via a spread bet. This difference - the fair value premium - is reduced if a share is expected to go exdividend at any time before the bet expires, since it is the shareholder and not the spread better who is entitled to receive the dividend income.

The adjustment for the interest and the dividend is purely an automatic calculation. The cost of carry will usually make the futures price higher than the cash price, but when a stock is paying a dividend this can actually make the futures price less than the underlying.

Spread betting directly on a traded futures contract such as the quarterly FTSE futures requires no such pricing adjustment because the cost of carry is already inherent in the futures price. Whenever the futures market is actually open, a spread betting company will simply wrap its spread around the relevant underlying contract price.

The situation is rather different outside normal market hours. Spread betting is a service and companies make a two-way price in the index futures even when the underlying exchange is closed, basing their quotes on the relationship between the FTSE and the closely-correlated Dow, S&P, Nasdaq and DAX.

At these times, a spread betting company is acting more like a bookmaker, essentially making up the stock index futures prices based on what the correlated markets are doing and the business on their books. Clients trading at such times may take on board a certain level of risk but many prefer to trade out of hours and see it as bargain hunting, in effect speculating on the day ahead.

The most widely reported figure for indices such as the Dow or the FTSE is the cash level, which is calculated from the weighted performance of all the constituent shares. This figure is not traded directly so when news breaks or there is a change in sentiment it is not really fully up to date until every individual share has traded. As a result, the cash price will often lag behind the futures market, especially when conditions are volatile, with contracts potentially trading at large premiums or discounts to the underlying share index.

Because the futures market is seen as the 'best' price, the spread betting companies use it as the basis of their cash quotes, simply making a fair value adjustment for the cost of carry. This means that it is both feasible and common for the cash level to actually fall outside of the quoted spread.

It is very easy to compare the headline index level with the spread betting quote and wrongly infer that the provider has marked up the price, while the true explanation is simply that the spread bet is based on the futures market. Such a misunderstanding can have a significant effect on someone's trading and may, for instance, trigger stops unexpectedly.

Any confusion over pricing can actually be avoided altogether when spread betting on individual equities using daily bets, where the quote is taken directly from the cash price of the share. These are ideal for the short-term trader, especially since the dealing spread is significantly narrower than for the corresponding quarterly bet.

Daily bets expire on the same day as the position is opened. However there is always the option to ask for it to be rolled over to the next day. Where this happens the opening level of the new bet will be adjusted to reflect the effect of interest and any dividends, but there will be no extra spread to pay.

Rolling cash bets, where the rollover takes place automatically each night until the bet is closed, have proved popular and many companies now support them. They are much more straightforward to compare with the physical market than the quarterly equity spreads. The spread is also tighter because the cost of carry that is inherently built into the futures bets is replaced by a separate overnight financing charge that is applied each day the bet is rolled over.

Ticking the box

You will often hear seasoned spread betters referring to a bet at 'so much a tick', or point. A tick is simply the smallest possible movement either way in the price of a security or commodity. An upward movement is an uptick and a downward movement a downtick.

Brought to you in association with MoneyAm Shares Magazine