What is Spread Trading: Meaning and Types

Over time, as the market for trading has evolved due to technology and the rise in disposable incomes, so too has the approach to trading changed.

There was once a time when one could employ the rather simple trading strategy of purchasing stock from a reputable and well established company (mostly from the banking, steel, mining etc industries) and holding it for several years until the value of that stock skyrockets. Indeed, many still do so.

However, with the onset of tech companies and the trading sphere moving majorly onto the online sphere, the number of these reliable companies has reduced. Additionally, as technology advances, these companies also see themselves being left behind in time (fuel and coal are not as valuable now that alternative energy sources exist).

In order to adapt to an increasingly complex market, traders, through experience and trial and error have come up with a plethora of trading strategies. One such strategy is known as spread trading. In this article we will understand what a spread trade is, all well how a spread trade works meaning the process behind executing a spread trade.

What is Spread Trade?

A spread trade is more accurately identified as a couplet of trades that an investor takes. One of which includes purchasing a certain future or option (though spread trades are used for other securities as well, these happen to be the most common) while the second includes selling off a second future or option simultaneously. Most often referred to as ‘legs’, the two securities part of the spread trade provide the change in price that the investor requires to turn a profit.

Often also referred to as ‘relative value trading’, the main agenda of traders employing the spread trading strategy is to capitalize on and secure profits from the spread when it narrows or widens.

Types of Spread Trading Strategies

Here are the common types of spread trading explained in simple terms:

1. Intermarket Spreads Traders make spread trades by buying and selling related securities on different stock exchanges, like NSE and BSE. For example, they could trade the same company’s stock listed on both exchanges.
2. Intracommodity Spreads This involves trading futures contracts of the same commodity but with different expiration months. For instance, a trader could buy a near-month contract and sell a later-month contract.
3. Intercommodity Spreads These spreads involve trading between two related but different commodities. For example, a trader might trade silver futures against gold futures.
4. Calendar Spreads Traders deal with futures or stocks of the same commodity or stock but with different expiry dates. For instance, they may buy a contract expiring soon and sell one expiring later.
5. Options Spreads Traders use options contracts to create spreads. These could involve vertical spreads (buying and selling options at different strike prices) or horizontal spreads (options with different expiry dates).

Example of Spread trading

Here are some simple examples of how spread trading works:

1. Commodity Spread: A trader buys gold futures for one month and sells gold futures for a different month to profit from price changes between the two contracts.
2. Inter-Exchange Spread: A trader buys a currency future on one exchange and sells the same currency future on another exchange to take advantage of price differences.
3. Inter-Commodity Spread: A trader buys crude oil futures while selling heating oil futures, benefiting from the price relationship between these related commodities.

Factors Affecting Spread Trading

Several key factors can influence spread trading:

1. Market Volatility: When markets are highly volatile, spreads may widen, which can lead to either unexpected gains or losses.
2. Liquidity: If there is low liquidity in the market, it can be harder to buy or sell contracts at desired prices, which may affect the spread’s profitability.
3. Interest Rates: Fluctuations in interest rates can change carrying costs, impacting the difference between contract prices.
4. Economic Events: Events like economic announcements or data releases can trigger sharp price movements, altering spreads significantly.

Benefits Of Spread Trading

Spread trading depends on the investor picking two commodities to trade that will help him or her mitigate their risk by hedging the two trades against each other. Experienced traders will look to hedge in order to protect themselves against price volatility in the short run, while still being able to hold on to their asset. The benefit here is that through a spread trade, the trader can define their risk and therefore act accordingly with this additional information.

Conclusion

Investors often prefer the spread trade meaning that they are able to define their risk and hedge it against their other security of choice in order to help minimise their risk as much as possible. Additionally, spread trading gives returns based on the difference between the prices of the two futures or options, allowing the investor to capitalise on the same. However, one must note that thorough research must go into the two futures or options that one employs in the spread trade as one has to pick two securities that have an inherent link between them.

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