How does the spread trading strategy work? A spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts. A spread tracks the difference between the price of whatever it is you are long and whatever it is you are short. Therefore the risk changes from that of price fluctuation to that of the difference between the two sides of the spread.
The spreader is a trader who positions himself between the speculator and the hedger. Rather than take the risk of excessive price fluctuation, he assumes the risk in the difference between two different trading months of the same futures, the difference between two related futures contracts in different markets, between an equity and an index, or between two equities.
The spread trade is also called the relative value trade. Spread trades are the act of purchasing one security and selling another related security as a unit. Usually, spread trades are done with options or futures contracts. These trades are executed to produce an overall net trade with a positive value called the spread.
Spreads are priced as a unit or as pairs in future exchanges to ensure the simultaneous buying and selling of a security. Doing so eliminates execution risk where in one part of the pair executes but another part fails.
The volatility of the spread is typically much lower than the volatility of the individual legs, since a change in the market fundamentals of a commodity will tend to affect both legs similarly. The margin requirement for a futures spread trade is therefore usually less than the sum of the margin requirements for the two individual futures contracts, and sometimes even less than the requirement for one contract.
You can enter a spread order at the market or you can designate that you want to be filled when the price difference between the commodities reaches a certain point (or premium).
You don’t have to watch a spread all day long. You do not need real-time data. These great advantages make spread the perfect trading instrument for professional traders and beginners.
The most effective way to trade spreads is using end-of-day data. Therefore, spread trading is the best way to trade profitably even if you do not want to watch or cannot watch your computer all day long (i.e. because you have a daytime job).
Even tose who daytrade use these advantages to optimize their trading results at the end of their trading day.
Just like everything in commodities, after you get used to the basics of spread trading you’ll become aware of more complex strategies that include but are not limited to things like: Condor spreads, Crack spreads, Crush spreads –the list goes on ad infinitum.
Spread trading can be very valuable and profitable but it’s important to start with the basics and then move on to the more exotic stuff when and if appropriate. Here are some basic pros and cons of spread trading:
– Spreads in commodity futures offer lower margin rates because these strategies usually carry less risk.
– Spreads are usually less volatile and prices move less quickly, which can be good for beginners who may be intimidated by the speed and price fluctuations of a single outright trade in the futures market.
– Spread trading offers unique hedging opportunities in a variety of commodities.
– Certain types of spread trading allow the trader to pay less in margin, funding the purchased future or option with the sale of the other side of the spread, thus reducing initial costs.
– Spread trading has much higher transaction (commission) costs because you’re using more than one trading vehicle. That’s why it’s even more important for a spread trader to have an excellent entry and exit point, because every penny will count.
– Spreads are often not traded “outright”; in other words on their own in some commodities, so you must “leg” into them, which can be tricky for the novice.
– Spreads can be less liquid than other trades, which could prove to be disastrous if you’re trying to get out of a position in a hurry.
– Spreads have limited profit potential most of the time.
– Spreads can be confusing, especially to the newer trader.
Spreads can be effective, but before entering into any spread trade figure out if you really have a reason to be using this type of trade, what purpose does it serve? If the answer is clear to you then go right ahead. Remember the most important thing to watch with spreads are those pesky transaction costs, they can really add up, fast.