Cost of Financing When Trading On Borrowed Money

There is an old saying along the lines of “never invest with borrowed money”, which makes perfect sense if you’re thinking about borrowing at a rate of 10% interest in order to secure an investment return of only 5%. Or, even worse, if your dodgy investment falls to zero leaving you still owing all of the money that you borrowed. Yet many of us do find ourselves willingly…

Trading and Investing on Borrowed Money

Many of us do borrow to invest: when we take a mortgage on a house or (in case you didn’t realise it) when we trade using ‘daily rolling’ spread bets — aka Daily Funded Bets (DFB) or Daily Funded Trades (DFT). Using borrowed money shouldn’t be a problem as long as we contain the downside risk by using a mortgage to buy a good house in a good area, or by diversifying our spread bet positions and using protective stop orders. And it shouldn’t be a problem as long as we expect any capital appreciation plus income (from renting the house or collecting dividends on our equity spread bets) to more-than-offset the cost of the borrowed money.

I’ll continue my mortgage analogy in my coverage of spread bet financing that follows.

Loving the Leverage

The reason with invest or trade with borrowed money is to multiply our purchasing power through leverage. When you put down a £20,000 deposit on a house, the mortgage lender might let you buy a £100,000 house, and if the house price subsequently rises by 20% (to £120,000) then your equity stake has doubled to £40,000 from your initial £20,000 investment. It’s exactly the same principle with rolling spread bets, whereby a £20 deposit allows you (for example) to take on £100 worth of risk by betting £1-per-point on a 100p-per-share equity. You should need to deposit £100 in order to cover the risk on that trade, but the spread betting provider lends you the balance of £80*. Rather like mortgage lender. And if the underlying stock price rises by just 20%, you’ve actually doubled your original deposit.

The margin % that you actually need to deposit in order to fund the trade will vary by spread betting company, with 20% being a working assumption in my example.

The Cost of Financing

Mortgage lenders and spread betting companies are not charities, and they expect to be paid some ‘interest’ for lending you money. The mortgage lender will charge interest on the £80,000 portion of the house that you don’t already own, and the spread betting provider will charge interest on the £80-worth-of-risk that you haven’t covered on your spread bet in my example.

In some cases the spread betting company will charge interest on the full £100-worth of risk, which is rather like a dubious bank charging you interest on the full £100,000 value of your own even though you own 20% of it outright. To some extent, though, this may be a moot point when assessed in conjunction with the interest rate charged; i.e. the spread betting company that charges 8% interest on your whole position is competitive with another spread betting company that charges 10% interest on the balance of 80% funding that they are lending you.

All other things being equal — which they rarely are — you would always want to secure the lowest possible financing cost on your house mortgage or spread bet positions. I’ll compare the spread betting providers shortly, but first here are a few words about…

The Long and Short of Spread Bet Financing

Whereas a spread betting company will charge you interest for holding a long rolling spread bet position, there is a theoretical (only theoretical in the current low-interest environment) possibility of them paying you interest on any short positions that you hold. As a short trader you are taking the opposite sides of the positions held by the long traders, and notionally you are lending them the money that they are borrowing. Just as you receive interest when you lend funds to mortgage borrowers by depositing your savings with a building society, so you expect to receive financing when you take the opposite side of someone else’s long trade.

The fly in the ointment here is that the building society or spread betting company takes its own ‘haircut’ en route between the lender (you as a saver or short spread bettor) and the borrower (the other guy with the mortgage or the long spread bet position). At the building society it’s a matter of them charging their mortgage customer 7% interest and paying their savers a lower 3% interest, and with spread betting it works like this:

• On a long spread bet they will charge LIBOR + 2% interest (for example)
• On a short spread bet they will pay LIBOR – 2% interest (for example)

With the London Inter Bank Overnight Rate (let’s pretend it’s simply the Bank of England “base rate”) at 10%, it would mean:

• On a long spread bet you would pay 12% interest
• On a short spread bet you would receive 8% interest

Interest rates haven’t been at 10% for some time, and with the “base rate” at a much lower 0.5% the numbers would look like this:

• On a long spread bet you would pay 2.5% interest
• On a short spread bet you would receive -1.5% interest

If you haven’t figured it out, I can tell it means that on a short spread bet you would actually pay 1.5% interest. And that’s why I described earlier the theoretical-only possibility of receiving financing costs on a short spread bet.

A Cursory Comparison of Financing Costs

Having set the scene by explaining what the financing costs of a spread bet are, how they are calculated, why they are charged at all, and what you get in return, you will no doubt be interested to know how the various spread betting companies stack up when it comes to financing costs.

The following table is correct to the best of my knowledge at the time of writing, but you should check with a specific spread betting provider before relying on this information. It shows the amount of interest charged above (for a long position) or below (for a short position) the “base rate” by the various providers.

And the winner is…

Before choosing a spread betting provider purely on the basis of this comparison, you should also consider the following caveats:

• The overnight financing cost is most relevant to longer-term position traders (like myself) and is of no relevance to day traders. You will be charged 1/365 of the interest charge for each evening that you continue to hold your daily rolling position, and you will incur no financing charge for bets that you open and close within the same trading day.
• There may be other criteria influencing your choice of spread betting provider. For example: you might choose IG Index at a higher +/- 2.5% rather than Gekko Global Markets at a lower +/- 2% because of the wider range of equity markets on offer from IG Index.

The standard overnight financing rate appears to be 2.5% with ETX charging at the higher end at 4.5%. Some providers have different policies on overnight financing according to whether the positions are long or short. For instance while City Index charges 3% on long positions, the rate they charge on short positions is 2%. Spread Co are even better in that they don’t charge on holding short positions. As such Spread Co have the most favourable policy for holding short positions (down bets).

Bux Markets have a policy whereby they will charge you only on the amount that you borrow – so if you put up 40% of your money as margin to maintain a position, they will charge you only on the remaining 60% [effectively on the amount you borrow from them]. As such it appears that Bux Markets have the most favourable financing policy and it effectively comes out as the lowest-cost provider of overnight finance on daily rolling spread bets.