You may have heard of forex spread betting and wondered how it differs from trading the traditional spot forex market. Spread betting is a betting-style derivative based on several other instruments, including currencies.
Rather than trading the underlying asset as you would in the spot world, one places a ‘wager’ on whether prices will go up and down.
If spread betting and trading spot forex both allow for profiting off fall and rising markets, what are the differences between them? Let’s find out.
What is forex spread betting?
To most, understanding the spot forex market should be the easiest, hence why it’s the largest in trading volume across all financial markets.
In spot, you assume a long or short position when you believe, based on predetermined analysis, that a currency pair will either appreciate or depreciate to some magnitude in value.
For example, if you went long on EUR/USD, you technically have specific units of euros on the trading platform. With spread betting, you are essentially placing a wager or a bet based on the number of points or pips a currency pair will either go up or down without any trading.
Another vital feature is this instrument has an expiry date, which may vary from trades closing before the end of a trading day, before the market closes, or even before the end of a quarterly cycle.
Example of forex spread betting
Let’s imagine a spread betting broker offered a EUR/USD quote of 1.1215. In this derivative, you have to determine your stake per point or pips and where you will exit in case the market went against you.
Let’s assume the trader decides to stake $5 per point with a maximum limit of $25. If the rate now went up to 1.1230 (15 pip difference), this would net them $75 ($5 X 15). Conversely, if the market were at 1.1210 (5 pip difference), they would lose $25 ($5 X 5).
The main difference between forex spread betting and the spot forex market
Spreading and trading the spot forex market is pretty similar as each method ultimately aims to capitalize on exchange rate differences. Both instruments are also leveraged products.
Fundamentally, spread betting (which originated from the UK broker, IG) is recognized as gambling (hence ‘betting’), while forex is a speculative investment with tax implications.
Although in spot forex, you don’t have inherent ownership of the currencies you trade, the difference is one trades the actual underlying asset that may incur a swap or rollover fee if positions are held overnight.
These charges come from the interest rate differentials between different currencies as speculating in them is taken as a means of investing in their respective countries. Therefore, trading forex is subject to investment regulations, while spread betting, as part of the name suggests, is subject to betting regulations.
Pros and cons of spread betting
Off the bat, we should recognize that as this instrument is a leveraged product, there is always a risk of substantial losses if one doesn’t trade responsibly. The only exception is the margin here is far less than in spot.
The one attractive characteristic with spread betting is that it’s primarily tax-free in most countries where it’s permissible, a stark contrast to trading spot forex.
It’s important to note this exclusion typically only applies when spread betting is not someone’s chief income source. This derivative is also generally commission-free and incurs no overnight fees.
- Spread betting enjoys a limited global reach, making it a market that few even know about, let alone understand. The smaller coverage also means fewer brokers are offering this product.
Additionally, more countries would likely ban spread betting if they have already prohibited other gambling forms. Currently, this market is permissible in regions like the UK and several countries in Europe, South Africa, United Arab Emirates, British Virgin Islands, Vanuatu, etc.
- Because of the drastically reduced leverage compared to its counterpart, one needs more trading capital.
- Due to having expiry times, this instrument is usually not appropriate for those planning to hold their positions indefinitely.
- Many people negatively connotate this instrument as a gambling form (even though it does differ slightly from the traditional definition).
Pros and cons of trading spot forex
Spot forex is a considerably more popular security for a few reasons outlined below. One of the drawbacks is the potential overnight costs and tax implications.
- The leverage in spot forex is a lot more flexible, allowing for a low entry barrier and requiring less risk capital to start (this can be a disadvantage if used irresponsibly).
- Spot forex has a broader worldwide appeal since it’s easily recognized and understood by many. Hence, countless brokers are offering this product.
- There is no expiry in the spot market (so technically, a trader can hold a position indefinitely).
- The high leverage can potentially cause massive monetary losses if treated carelessly.
- If one is a long-term trader, they will mostly have to deal with overnight charges (swaps). Depending on the pair and the broker, these swaps could make a dent in one’s profits.
- In most countries, withdrawals from forex count as capital gains or a similar kind of payable tax.
So, should someone spread bet or trade spot forex? The only distinction with the former is the exclusion of tax. For some, this alone may be a good enough reason to consider trading currencies with this approach since it’s more cost-effective.
Spread betting may also suit short-term traders due to having an expiry date. For traders who hold their positions for much longer and where tax is not a significant issue (depending on the country one resides from), they would be better suited speculating in spot forex.