Spread betting companies are in essence market-makers. They provide liquidity to the market by standing ready to take the other side of trades, earning the bid-ask spread for this service.
Spread betters are in essence market-makers just like the traditional stock broking firms. They earn their keep not by making speculative punts on the direction of the market or an individual stock, but instead profit from different market participants crossing their bid-ask spread to go long or short.
They make a little bit every time there is a buy and a corresponding sell on a market for which they quote. The greater the volume of trade the greater their profit. They are providing a service to the market by offering liquidity – meaning they allow traders to go long and go short at their chosen price or at their chosen time. They stand ready to quote at any time and in any market conditions. They are also indifferent to the direction in which the market goes in and seek to earn a profit in this manner in bull, bear and range-bound markets.
As it is in their interest to see high volumes going through their books then it is in their interest to encourage trading by offering competitive spreads – meaning tight spreads. If their spreads are wide this will mean a greater profit each time the bid-ask spread is crossed but it will not entice traders to trade with them. If the spreads are narrow it will encourage trade but the profit for each cross will be less and there will also be a greater risk to the spread betting company of the market going against them. So they continuously need to keep a balance between the two especially in dynamic markets.
If markets did not move, the market makers job would be very simple. They could offer a very tight spread enticing all market participants to engage with them as the risk of the market going against them would be zero. Ideally, every time someone goes long they would prefer another participant to also go short the equivalent amount meaning that the company’s exposure is flat.
Of course, in the real world, markets can and do move sporadically. Therefore, when many traders are going long a certain instrument with a sole spread betting company it will adjust its ask price upwards. This will have the impact of increasing the bid-ask spread if the bid price is kept where it is. However, if the company wants to reduce is exposure it would likely also increase its bid-price to encourage more sellers to come to the market.
Therefore the spread betting company will react with the market. It will not keep its prices static as activity levels increase in one direction relative to the other. When the company adjusts its ask price upwards the impact of this is two fold. Firstly, it is less appealing for traders to go long as they will be ‘paying up’, that is, buying at a higher price. This in-turn protects the spread betting company, if only temporarily, from its exposure increasing. Secondly, as it adjusts the ask price higher it will be selling at an ever increasing price, so even though its exposure is increasing each ongoing trade will be at a more favourable price for the spread betting company.