Spread betting commodities

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For many investors, one of the revelations of the last few years has been the money that can be, or could have been made, through exposure to commodities. Not just the obvious homes for money in times of stress - like gold and oil - but also commodities of a more mundane hue.

If it looks an easy way to make money, there is probably risk attached.

One of these risks in this case is the obvious one that trading commodities is essentially a professionals market. Many 'soft' commodity markets are dominated by food producers to such an extent that poor timing and random events can produce big losses for the unwary. A second risk is that most commodities are priced in US dollars, which layers in an additional dimension of currency risk.

In this latter case, some of the more popular markets tend to be self-correcting. Students of the gold price cannot fail to notice, for example, that weakness in the dollar tends to produce, other things being equal, a rise in the gold price.

Getting exposure to commodities through spread betting goes back a long way. The origins of IG Index reflect this. The initials stood for Investors Gold. Stuart Wheeler founded the company on the back of City traders' wish for an easy way to punt the gold price back in the 1970s.

Spread bets offer a way round the currency risk. Spread bets on gold and oil, for example, are denominated in sterling, so a $10 move in the gold price would generate a £10 profit or loss for someone spread betting at £1 a point. The same system applies to spread bets in other precious metals like silver and platinum.

This contrasts with the price of a gold or oil ETF. Take gold, for example.

Gold ETFs are typically denominated in dollars, as you would expect. But if, as a UK investor, you buy shares in a gold ETF, the brokers will work out the consideration for the deal on the basis of the sterling equivalent. So your exposure in this instance is to the sterling equivalent gold price - in other words with currency factors built in.

In precious metals, both with spread bets and ETFs, there is an advantage over physical bullion, be it in the form of coins or small bars, where not only do you pay the sterling equivalent price, but also a premium on top, supposedly for 'fabrication', but in reality to give the dealer a margin. Even in the most popular gold coins, Kruger rands for example, this can be as much as 5%.

Modest outlay

Spread bets also allow you to gain exposure for much more modest outlay than would be possible either via purchase the product in physical form (via gold bullion coins or bars, for example) or through the futures market.

Spread bets also allow for shorting, which is more complicated to do in ETFs and by definition cannot be done in physical bullion. You either own it or you don't.

Shorting may become a useful tool in commodity markets in the next few years, after the long bull market and vast price increases that have been seen in recent years. But it's a different discipline. As in the stockmarket, price drops are sharp and unpredictable, advances often slower and more methodical.

Finally, spread betting involves leverage. It's important to make sure that you don't use the leverage involved in spread betting commodities just because it's there. Use it rather to economise on the capital you might commit to a notional physical investment in the commodity. It's also particularly important to have an account that allows for the use of stop-losses to limit your risk if things go awry. IG, for example, offers a 'controlled risk' bet for a premium of three 'ticks'.

The 'tick' size is the smallest unit for price movement, in this case 10 US cents. Shorting gold at $930, for example, would mean your opening price, with a controlled risk premium subtracted, would be 929.7. When the offer price on the spread drops below this level, you start to make money. Some companies offer a minimum bet size of £1 a point in gold, effectively meaning that you are risking £1 for every $1 movement in the gold price.

You must, however, double check the unit size in which the bet is denominated. This can differ from firm to firm and from commodity to commodity. In some cases, a £1 a point bet could be risking £10 for every $1 movement in the price.

The same system works for other commodities.

Spread betting firms offer a wide range of metals, soft commodities, energy prices, some contracts based around the spot price and some based around longer term futures prices. Most spread betters trade gold and oil, although there are occasional flurries of interest in certain soft commodities.

Peter says

I've long been a fan of gold and gold shares, however, I get my exposure through physical bullion - a stash of Kruger rands and other bullion coins stored in a safe deposit box - and a professionally managed fund of gold shares.

If and when the gold price looks overextended, I may reactivate an old spread betting account and hedge my exposure by shorting the price up to an amount commensurate with my exposure. But that is about as far as it goes, and for the moment I believe that gold has appreciably further to run.

I have been able to resist the lure of spread betting commodities. It is perhaps significant that even the spread betting firms themselves, in their marketing literature and on their websites, will stress how volatile commodity prices can be - especially in certain soft commodity categories.

The golden rules of spread betting for me are therefore: steer clear of soft commodities; always use a controlled risk bet with a sensible stop-loss; don't go away on holiday and leave any form of spread bet open; and only use the leverage offered by spread bets to economise on the capital you have employed, not to increase the size of your exposure above what you would have if you were buying the commodity in physical form.

Even then, be prepared to lose money.