The Fundamentals of Spread Trading

What Exactly Is Spread Trading?

Are you looking to become a skilled spread trader? Have you always been interested in the field but didn’t know much about it? Well, look no further! In this article, we will tell you all you need to know about spread trading.

A spread trade, in finance, refers to a type of futures trading in which the purchase of one security and the sale of a related security both take place simultaneously as a unit. Each sale or purchase is referred to as a ‘leg’. The purpose of spread trading is to mitigate the risks of holding only a long or short position, since it combines both a long and a short one.

Typically, spread trades are executed with options or futures trading contracts as the legs, but you can also choose to use other securities. No matter what you decide, you stand to gain an overall net position whose value, referred to as the spread, will depend on the price difference between the two legs.

So if you’re new to investing, or if you are not a big fan of taking risks, the spread trade is perfect for you. It gives you a chance to invest, earn some money, and gain investment experience without taking too great a risk.

Some Basic Terminology

For those of you who are new to finance, let us explain some basic terminology before moving on so that you will be able to understand as we continue further.

  • Futures Trading – A futures contract is a standardized contract between a buyer and a seller regarding a specified asset of a certain quantity and quality, for a price that is agreed upon in the present. However, delivery and payment will occur at a later, specified date.

 

  • Delivery Date – The specified date where the previously agreed on futures trade will take place.

 

  • Short and Long – In futures trading, the buyer of the asset is said to be ‘long’, while the seller of the asset is said to be ‘short’. Typically, the one in the long position would hope for an increased price of the asset, while the one in the short position would hope for a decreased price.

Benefits of Spread Trading

Are you wondering what the benefits of spread trading are? Well, it provides a way for investors to take advantage of market imbalances by using a relatively small investment up front to make a huge profit.

Not to mention, it is great for the conservative investor since it makes for a great hedging strategy by lowering portfolio volatility and reducing bias. This is because spread trading entails combining a long and short position, which avoids the risks of holding only a long position or a short position.

So How Exactly Does Spread Trading Work?

Still don’t understand how it works? Don’t worry; you’re not the only one. It’s always a little hard to understand at first. Let’s try to look at it in a real world context application.

Let us start with a simple example and look only at one leg first. Suppose you invested on a trade spread in gold. However, after your commodities trading contract has been signed, gold increases in price. You have gained on the long position (recall: ‘long’ = buyer). This is because the amount of gold you purchased in the past has become of greater value compared to what you previously agreed to pay for it. As such, your gain on the long position will be able to offset the loss on the short one.

Does it seem a little clearer now? No? Let us add in the other leg and throw in some numbers to help you see the big picture.

Say, for instance, that it is now August and you want to buy a September silver contract for $50 per gram and sell a December gold contract for $70 per gram, both on the Kansas City Board of Trade. So you enter it all on an online trading spread order, rather than separately as one long position and one short position. You now have a difference of $20 per gram. Now, you only face a risk of widening or narrowing the margin, instead of having two separate investments to worry about. Gains on one leg can offset losses on another, and vice versa.

So as you can see, spread trading is really a protective trading arrangement. It reduces the risk of your decision to invest, since regardless of whether the legs move in the direction of your expectation or not, you will still stand to gain in the long run. Of course, it also means that your profit margin will be smaller, but don’t you think that’s a small price to pay for the reduced risk?

Different Spread Types You Should Know

There are various basic spread types that any investor worth his or her salt should be able to identify. The following are some of the basic taxonomy of spread types. They can be classified into three different categories – commodity, market, and delivery.

Commodity

  • Intracommodity – the spread is on the same commodity
  • Intercommodity – the spread is on different commodities

Market

  • Intramarket – the positions are traded on the same exchange market
  • Intermarket – the legs of the spread trade are on different exchange markets

Delivery

  • Intradelivery – the contracts will mature in the same delivery month
  •  Interdelivery – the contract will mature in different delivery months

Here is an example you can use to check if you have fully understood the taxonomy of the different spread types:

Let’s say that a customer has invested in long December copper and short March silver. They are both traded on the New York Mercantile Exchange. Are you able to identify what type of spread this is?

Here’s the answer. The spread trade is intercommodity, since copper and silver are different commodities. Yes, they are both metals, but they are different types of metals. The spread trade is also intramarket, since both legs are traded on the same market, the New York Mercantile Exchange. Lastly, this spread trade is interdelivery. This is because one leg is delivered in December, while the other is delivered in March; the two contracts mature in different delivery months. How’d do you? If you answered correctly, great job! If not, don’t worry. Just review the basic terminology again.

 

 

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Symbol Bid Ask Spread
EURUSD 1.16440 1.16460 2
GBPUSD 1.30180 1.30210 3
USDCAD 1.25060 1.25090 3
USDJPY 111.850 111.870 2
USDCHF 0.95250 0.95280 3
AUDUSD 0.79020 0.79050 3
NZDUSD 0.74220 0.74270 5
EURGBP 0.89430 0.89460 3
EURCHF 1.10920 1.10950 3
EURJPY 130.250 130.280 3
AUDJPY 88.380 88.430 5
GBPJPY 145.610 145.670 6
XAUUSD 1247.75 1248.15 40
XAGUSD 16.427 16.436 0.9