The Price Is Right
By Nick Sudbury*
Posted: May 5, 2006
Spread betting can be an ideal way for people to try out margin trading for the first time, but some who make this transition can find the pricing confusing. Any perceived lack of transparency with these over-the-counter products can easily undermine confidence and lead to errors when trading.
The two variables that define a spread bet are the underlying instrument and the time frame because, taken together, these determine how the bet will settle if held to expiry. The time element means that, if you are betting on a stock index future, the mid-point of the spread will not normally be the same as the current cash market price from the LSE.
For example, with several weeks to run to expiry, a particular spread was quoted at 1352.5-1354 while the underlying was actually trading at 1348-1349. Premiums such as this are purely mechanical and in no way imply a bullish view of the stock.
The fact that the spreads are quoted at a premium to the underlying reflects the sacrifice of interest that a trader experiences by 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 ex-dividend at any time before the bet expires because it is the shareholder and not the spread better who is entitled to receive the dividend income.
Most spread betters understand that 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, which can really throw them.
Stock IndicesSpread 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.
For example, with the FTSE cash trading at 6012 in March, the March futures contract was 6013 and the June contract 6022. 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 of normal market hours. Because spread betting is a service, many of the providers will make a two-way price in the index futures even when the underlying exchange is closed. Some will even quote the major equity index contracts 24 hours a day although, typically, the spread is higher outside of normal market hours -- the quarterly FTSE futures spread rising from 8 points to 10 points after 16.30, for example.
Outside of normal market hours, a spread-betting company acts more like a bookmaker, essentially making up the FTSE stock index futures prices based on what the U.S. markets are doing and the business on their books. Clients who choose to trade at such times inevitably take on board a certain level of risk, but many actually prefer to trade out of hours and see it as bargain hunting; in effect, speculating on the day ahead.
PricingSpread betters who are not clear on how the quotes are derived are in danger of misreading the situation. By contrast, those who understand where the prices come from can take advantage of innovations such as one-click spread betting, which allows traders to deal online almost instantaneously with a simple click of the mouse.
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 well 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 quote, 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.
As well as quoting monthly or quarterly equity index futures, most of the spread-betting companies also offer daily bets on the major UK, U.S. and European stock indices. These typically include a daily FTSE 100 future, which settles on the official futures close at 16.30, and a daily FTSE that settles on the official cash close. Effectively, these are just the same market with a fair value adjustment, but there are differences that can catch the unwary.
Misunderstanding prices is certainly more of a problem for people on the daily cash and the daily futures than it is on the quarterlies. Spread betters who are not clear on the way the prices work can get particularly upset when a significant news event occurs or an economic report comes out because that's when the responsiveness becomes a major issue, with the futures reacting that much more quickly than the cash price.
It is very easy to compare the headline index level to the spread-betting quote and wrongly infer that the provider has marked up the price when 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. A spread-betting company should, of course, be able to justify its prices although this is likely to be of little comfort to anyone who has been caught out by this sort of misunderstanding.
Rolling CashAny confusion over pricing can actually be avoided altogether when spread betting on individual equities by using the now widely available daily bets, where the quotes are taken directly from the cash price of the share. These are ideal for the short-term trader, especially because 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 would be adjusted to reflect the effect of interest and any dividends, but there would be no extra spread to pay.
If someone takes out a daily bet and a futures bet and holds both over the full term of the future, then, theoretically, the cost-of-carry adjustment would be the same; it's just that, with the daily, the adjustment is made separately everyday.
Rolling cash bets, where the rollover takes place automatically each night until the bet is closed, have proved incredibly popular. This is because they are transparent and ideal for short-term trades because spread betters don't have to think about whether the price is where they want it to be; they can see it straightaway.
Not only is the rolling cash price that much easier to understand, the spread is also tighter because the cost of carry inherently built into the futures bets is replaced by a separate overnight financing charge applied each day that the bet is rolled over. This makes rolling cash bets more analogous to Contract for Difference (CFD) trading -- albeit with the added benefit of any gains being tax free.
*The full version of this article was originally published in Shares magazine and is reprinted (and modified) with permission from Nick Sudbury.
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