Risk & Leverage

Spread Betting is the flexible and tax-efficient* way to back your judgement on a range of financial markets. However, without an effective risk management strategy, it can also lead to substantial and quick losses. It is therefore important to understand risk and learn how to manage your portfolio effectively.

Why do I need to manage risk?

Leverage

Unlike most traditional financial dealing services, Spread Betting is a leveraged product. This means that your initial deposit payment gives you exposure to a comparatively larger portion of an underlying market than if you bought the instrument directly (via a stockbroker for example). Leverage is one of the key advantages of Spread Betting, as it allows you to profit from a market without having to put up the full value of the position.

However, this magnified exposure also means that Spread Betting can result in losses that exceed your initial deposit. And without good risk management, it becomes possible to make significant losses over a short period of time.

One way to understand leverage is to compare it to buying a house. Imagine two investors buy identical houses for £500,000 each. Investor A pays 100% cash, and Investor B pays just 10% and borrows the rest. For the sake of simplicity we will assume the loan is interest-free.

After a few years the value of the houses rise to £750,000 and both investors decide to sell. Investor A is very happy, his £500,000 is now worth £750,000 and he has made a 50% profit on his original investment. However, Investor B is even happier. He paid £50,000, and borrowed £450,000; after paying off the £450,000 loan, he is left with £300,000 in cash. He therefore has a £250,000 profit on his original £50,000 investment, or a profit of 500%.

Had the price of the property fallen to £250,000, both investors would be looking at a loss. If they sold their properties, Investor A would make a loss of £250,000 (50%), and Investor B would lose his £50,000 deposit and need to pay a further £200,000 - a total loss of £250,000 (500%) - negative equity. This clearly demonstrates the high-risk nature of leveraged dealing.

For example:

If you bought £10,000 worth of ordinary shares, you would be expected to pay the full £10,000. However, if you opened a £10,000 Spread Betting position in an equity with a required margin of 10%, you would initially only need to pay £1,000 (10% of the value). This means that you control the same size asset with a much smaller amount of money - in this case £10,000 for just £1,000. This 10:1 ratio means you have an investment with 10 times leverage. Therefore, assuming there was no spread, if the underlying share price went up by just 5%, you would make a profit of 50% - although if it went down by 5% you would also make a loss of 50%.

Calculating the initial deposit required

Details of initial deposit requirements can be found in the Dealing Handbook, but for now we will look at the two most popular types of instruments - equities and indices.

Equities

The amount you pay up-front is calculated as a percentage of the full value of the contract, which in turn is your stake multiplied by the price. Initial deposit for equities in the FTSE-350 is usually 10%, so the deposit requirement payment for a £20 bet on Vodafone at 140p would be calculated as follows:

Please note, IG Index may hold a position in Vodafone in the ordinary course of business.

Indices

Each index contract has a fixed Deposit Factor associated with it - for example, the FTSE-100 contract ('UK-100') might have a Deposit actor of 200. The Margin Requirement payment is calculated by multiplying the Deposit Factor by the amount of the stake. So for a £5 bet on the UK-100 contract it would be:

When you have calculated your initial deposit requirement, you will need to ensure that you have sufficient money on your account to cover it before you will be able to open the trade.

How do I manage risk?

Understand your market

Before dealing, it is important to understand the market on which you are taking a position. Knowing the potential for each market to experience volatility and establishing the likelihood of sharp price movements is essential when considering the risk associated with each bet. For example, historically, some markets are less likely to make sudden discontinuous jumps, while others, such as shares (which can be subject to profit warnings and the like), may be more likely to make abrupt movements.

Enrolling in the TradeSense course will allow you to benefit from a full module on risk management, including information about how to maintain a balanced portfolio and manage your personal risk/reward expectations.

Monitor your open positions

An equally important risk management strategy is simply to closely monitor your open positions. This is particularly relevant if you have not attached a Stop-loss. Volatile markets can move hundreds of points in minutes, and while a good understanding of your market may help pre-empt extreme fluctuations, there is no substitute for actively monitoring your account.

However, there will inevitably be times when it is impossible to keep an eye on your open positions. This is why you will have access to a powerful range of tools to help you manage risk without capping your potential for profit.

Using Stop orders

When you open a position, the most effective way to manage risk is to put an absolute cap on your potential loss by using a Guaranteed Stop. This means that you specify the level at which you want your bet to be closed should the market move against you. In return for a slightly wider dealing spread, IG Index guarantee to close your position at that exact point, even if the market gaps suddenly. With a Controlled Risk bet (a bet with a Guaranteed Stop attached), your maximum possible loss is known as soon as you open the position, making it an extremely effective risk management tool.

You also have access to non-guaranteed Stops, which do not incur the premium associated with Guaranteed Stops but can also help manage risk. A non-guaranteed Stop will trigger an order to close your position once the selected level has been breached. However, you should be aware that it will sometimes not be possible for the Stop Order to be transacted at the price you have selected. This may happen overnight or when the market moves very quickly. In these cases the Order will be transacted at a worse, and sometimes much worse, level than you have selected. This is known as 'slippage', and is determined on a basis which IG Index believe to be fair and reasonable. For more details on slippage please see the Dealing Handbook.

Trailing Stops are non-guaranteed, but track your position while the market moves in your favour, providing protection if it starts to move in the other direction. This allows you to lock in profits without the need frequently to re-adjust the level of your Stop.

Using Limit orders

A limit order triggers an order to close once a specified market level has been reached. It is an instruction to take profit if prices move in your favour. This means you can realise a pre-selected level of profit, even if the price later moves against you.

Stop and Limit orders are available over the phone as well as online, meaning you can manage risk wherever you are.

Types of Bet

Some of the bet offered are automatically limited risk and these can be of use when trying to minimise risk on your Spread Betting portfolio. For example, if you open a Bungee Bet, the amount you can lose is known in advance but you can benefit from favourable market movements. Binary Bets also allow you to work out your maximum potential loss before opening the bet.
 
Buying an Option is also an inherently limited risk bet. Please note that this is not true when selling Options, for which risk is, in principle, unlimited.

Risk and Account type

The amount of risk you are willing to take may affect your choice of account. There are two main accounts, the Limited Risk and the Plus account.

With a Limited Risk account, a Guaranteed Stop is placed on every position you open and you can never lose more than the amount of your initial deposit. Please note however, if you place a bet denominated in a currency other than your base currency, you will be exposed to currency fluctuations. IG Index may then convert any profits or losses in this currency to your base currency. Due to the possibility of currency fluctuations, this could result in your account incurring a further loss, beyond your initial deposit.

The Plus Account allows you to make bets with or without Controlled Risk. If you open a position without a Guaranteed Stop and the market moves against you, you must have sufficient cash on your account to fund the deposit requirement as well as the total of your running losses. If you do not, IG Index may cut back or close your open positions. If IG Index choose to do so, this can help prevent your losses becoming more substantial. While this offers some level of risk protection, you should not rely on IG Index to close your losing positions and should use any of the risk management methods mentioned above.

*Tax law can change or may differ in a jurisdiction other than the UK.