The financial markets allow traders to explore different trading methods. Two common ways to trade, binary options and spread betting, are popular in the UK, especially among forex traders. These trading forms allow traders to speculate on market changes and price movements. However, the basic principle, potential returns, and tax implications differ.
Spread Betting
The popularity of financial spread betting (FSB) among traders is due to its flexibility. It allows traders to speculate on markets and enjoy tax-free profits without owning the underlying assets. Spread betting comes from the spread, the difference between an asset’s bid and ask prices, which could be stock indices, shares, metals, bonds, currency pairs, or commodities.
Traders predict the direction of the asset and go long (buy) or short (sell) in line with their prediction. The more the market moves in that direction, the more profits they make. Traders can close their spread bets at any time by simply trading in the opposite direction of the open trade. For example, a long trade will be closed when the trader clicks the sell order.
Suppose you want to bet on the value of the British pound against the US dollar (GBP/USD). You bet $10 per point that the price will go up. If the price moves in your favour by 5 points, you earn $50 (5 points x $10). If it moves against you by 5 points, you lose $50.
Binary Options
Binary options trading is a type of investment where you predict whether the price of an asset (like a stock, currency, or commodity) will go up or down within a set time. It’s called “binary” because there are only two outcomes: you either win or lose. When you trade binary options, you don’t own the asset itself. Instead, you’re betting on whether its price will be higher or lower than a specific value at a certain time.
For example, you predict that the price of Apple stock will rise within the next hour. The current price is $150. You invest $100 on your prediction. If the price goes above $150 in an hour, you win and earn $180 (your $100 investment + $80 profit). If the price stays below $150, you lose your $100 investment. The profit is determined by the payout percentage offered by the broker at the time of the trade. The payout percentage is predefined before you place your trade, so you always know how much you will win or lose.
Differences Between Spread Betting and Binary Options
Six main points distinguish binary options from spread betting. These are important factors that traders consider before exploring markets.
Basic Principle
Spread betting differs from binary options primarily in its mechanism. Spread betting lets traders speculate on the market direction without owning the underlying asset or purchasing a contract. In binary options, however, traders place a bid, betting on the market to rise or fall within a specific period.
Profit Potential
Trading involves buying, selling, or exchanging one instrument/asset for another. Since the end goal of trading is to make profits, traders open and close positions in the direction they think the market would go. This is important because making profits depends on how markets move and the profit structure of the method.
In spread betting, traders get returns based on their lot size and market movements. Traders with bigger positions would make more profits if markets moved greatly. However, traders get a fixed return or nothing in binary options based on market movement. Potential profits are limited because of the cap on initial trading amounts.
Leverage
Most brokers allow traders to amplify their positions, opening larger positions with a smaller initial amount. Although this helps traders make more returns, it can also increase the amount lost. Although leverage is permitted in spread betting and binary options trading, they operate slightly differently.
In spread betting, leverage enhances winning and losing positions, so traders must carefully leverage positions and monitor trade to prevent drawdowns that can cause margin calls. Binary options traders can only lose the amount used to open a position, even when they use leverage.
Regulation
Trading is a regulated activity globally due to potential financial and economic impacts. The UK’s Financial Conduct Authority (FCA) regulates brokers and financial trading as investment activities. Spread betting is legal in the UK and is regulated by the Financial Conduct Authority. This is because the FCA considers spread betting to be a derivative product and regulates related activities. However, The European Securities and Markets Authority (ESMA) and FCA have banned binary options trading within the UK and EU.
Risk Management
Risk management is a critical aspect of financial trading, and strategies used to manage trades help traders maximise returns, protect their capital, and stay profitable over time. Although the principle is similar for all markets, specific risk management strategies differ.
In spread betting, for instance, traders can manage risk using take profit (TP) and stop loss (SL) orders. These orders automatically close trades when they reach certain prices. In binary options, traders do not have the options of SL and TP to manage trades. Binary options have expiry limits, usually from three seconds to a year. Some brokers allow traders to close their options quickly, while others do not.
Tax Implication
In the UK, taxes typically apply to any activity that yields profit or income. Trading, buying, or selling assets fall under various income tax brackets. However, there’s another important distinction between spread betting and binary options. While binary options trading is taxable, spread betting is largely tax-free within the UK.
Neither Capital Gains Tax (CGT) nor stamp duty applies to profits from spread betting, and traders keep 100% of whatever they make. This is why spread betting is more attractive to traders than Contracts for Differences (CFDs), binary options, and others that are taxed. Although new tax rules will take effect in 2025, spread betting will remain tax-free for the foreseeable future.
Trading Spread Betting
Spread betting and binary options trading are not the same. The former offers more flexibility across financial markets and has a better profit potential than binary options. It is important to trade with a UK-regulated broker to ensure that traders get competitive spreads in the market. As always, to become profitable, traders should leverage charting and risk management tools and master their emotions when making trades.