With stock markets as volatile as they are now, you might consider that you are taking enough of a gamble merely by investing in equities at all. But there is actually a form of gambling that can help protect your portfolio from the current market mayhem. It is called financial spread betting, and its advocates claim it can both help you manage your portfolio more efficiently, and reduce the cost.

But as its name suggests, spread betting is still a bit of a punt. You must do your research and take measures to protect yourself, or you could lose your shirt.

What is spread betting?
The principle behind financial spread betting is surprisingly simple. After you have made a couple of practice trades, with low stakes on a share or index you understand, you should have grasped the basics. A spread bet always quotes two prices. For example, the spread on the FTSE 100 may be 5404 – 5410. The broker makes his profit on the difference between the two.

Say you decide to take out a financial spread bet on the FTSE 100. If you think the index is set to fall, you would ‘sell’ the index, and you would ‘buy’ if you think it is likely to rise. The next step is to decide how much to bet. IG Index allows you to bet as little as 10p for each point it moves; other spread betting sites set a minimum of 50p. That doesn’t sound much, but if the market moves swiftly against you, even a relatively small bet could translate into a sizeable loss.

So with the ‘sell’ bet, if you bet £1, you win £1 for each point the index slides down from 5404. So if it slips 79 points to 5325, you have won £79. If you were brave enough to bet £10 per point then congratulations, you have won £790. You are free to close your bet at any time and bank your winnings.

Like any flutter, spread betting is risky. It is even riskier than placing a fixed-odds bet at the local bookies because you could lose much more than your original stake. If the index rises, you will lose £1 or £10 for each point it moves up from 5410. If it shoots up 300 points, and you bet £10 per point, you have lost £3,000. So to protect yourself, it is worth setting up a stop-loss first. Indeed, some spread betting sites insist on it.

But, as you can see, spread betting allows you to make money both in falling and rising markets. That means you can also use it as a simple hedging instrument to protect your wider portfolio from adverse market movements. This is where it starts to get a bit more complicated.

Hedging your bets
Say you’re worried that falling stock markets could drag your equity portfolio down with them, but you have good reasons for not selling out – you don’t want to pay the dealing charges, or maybe you will incur a capital gains tax bill. Or perhaps you can’t be bothered liquidating the entire portfolio and repopulating your stock later. Plus, of course, there is the possibility that you don’t want to run the risk of being out of the market.

You could protect your portfolio by taking out a spread bet instead. This can help you mitigate any short-term losses and, by keeping your portfolio intact, help you make a long-term profit when markets recover. It is also cheaper than selling up your portfolio, because, unlike share transactions, there is no stamp duty, no broker charges and no capital gains tax on any winnings.

If you have a £50,000 portfolio of mostly FTSE 100 stocks and are worried the index will fall then you could sell the market at £10 per point. If it drops 500 points from 5000 to 4500, you will have made £5,000 to offset the losses on your wider portfolio.

Of course, if the market charges in the opposite direction, the losses on your spread bet will cancel out the gains on your portfolio. So you have to call the market right. However, you don’t have to put up as much cash with a spread bet as if you are actually buying a share.

Joshua Raymond, market strategist at spread betting site Finspreads, explains, ‘Typically, you will be required to put down a margin of ten per cent. That means you can protect, say, £10,000 worth of Vodafone shares with just £1,000 worth of capital. A lot of our clients have tried this. It is very useful in times of uncertainty.’

He also suggests that you have to examine your reasons for hedging. ‘The main reason is uncertainty. You think your position will go down, and decide a bet can protect you. Once the uncertainty has ended, you can close your bet and enjoy the profit on your physical portfolio.’

Protecting against uncertainty
You can also use a spread bet to hedge against acute short-term uncertainty, for example if one of your holdings has called an emergency general meeting. ‘You can use a spread bet to go short until the profits forecast is out. As soon as the uncertainty is over, you move out of your hedging position,’ Raymond says.

If the stock slips, your spread bet will offset any losses. If it barely moves, you can close your bet without incident. But if it shoots up, then you could be in trouble – at least until your stop-loss kicks in.

Raymond says another financial instrument, contracts for difference (CFDs), may be a better way of hedging your portfolio. ‘Many professional investors prefer to use CFDs for hedging and spread betting to speculate. The advantage of a CFD is that you can offset your losses against any capital gains you may have made elsewhere, cutting your tax bill. You can’t do that with a spread bet.’

David Jones, chief market strategist at IG Index, says you can place a spread bet on almost any financial instrument, including stocks, indices, house prices, currencies and commodities: ‘Given the current volatility, oil, gold and agriculture have been very popular among our clients.’

If you are hedging your portfolio over a longer period, such as six months, you don’t have to worry too much about day-to-day movements; unless, of course, they breach your stop-loss, triggering a sale and crystallising your losses. ‘That way your hedge could wipe out any gains on your physical portfolio, which you really don’t want,’ Jones says.

Given the dangers, he sometimes questions why anyone would use a spread bet to hedge their portfolio: ‘If you are really convinced the market is about to collapse, maybe that is the time to sell and take your profits.’

Understanding the risks
Others argue that in today’s ultra-volatile markets, spread betting is just too risky a method of protecting your portfolio. David Buick, market strategist at Cantor Index, says the investment world has changed radically in the past 12 months, and so has spread betting. ‘The market is much more volatile and sophisticated than just a couple of years ago.’

He argues, ‘Look how quickly markets rose when the US government stepped in to save Fannie Mae and Freddie Mac. And how quickly they fell the next day, after the crisis at Lehman Brothers. It was explosive. Spread betters must be significantly more savvy and in touch with the world of finance on a minute-by-minute basis than ever before.’

Buick argues that this means you no longer dare take a long-term spread bet to protect your overall portfolio: ‘Commodities like oil and gold, the FTSE 100 and individual stocks are extremely volatile. You have to be incredibly light on your feet. Spread betting and CFDs used to work well, but now you can take a real beating.’

To illustrate the danger, Buick considers an investor who wants to protect a £300,000 portfolio against falling markets by taking out a spread bet to sell a global index at £100 per point. ‘If a knight in shining armour suddenly steps in to save a struggling bank such as Lehman, and the index surges 300 points, you face a £30,000 margin call. You might find the only way to cover your losses is to sell your stock. This means your judgement has to be supreme. There is no room for error.’

The conclusion is that spread betting is most useful when it is least sophisticated and is used over a short period of time. Buick says, ‘The key is to find a trend. Decide what is going to happen. Give yourself two or three days to make your money, no longer. Then take your profit and go in peace. That’s the way to make it work.’