A spread trade is a financial term that is used to refer to the simultaneous buying of a security and selling of a related security (legs) as one unit. A spread helps in tracking the difference between of the security you have in abundance to that of the security you are short.
Units for the execution of spreads are usually are either future contracts or options. Future contracts are standardized quantity and quality of a price used in exchange of a specified asset of standardized quality and quantity for a price agreed by both parties.
On the other hand, an option is a yardstick specifying a contract between business parties. This is for future transaction of an asset at a reference price. Spreads are commonly priced and often traded as units of future exchanges rather than individual securities.
Through spreads, the risks associated with the business change for that of fluctuation of prices to that of the difference between the companies spreads that is also referred to as the net position of the firm. The rate of change to the spreads is relatively inelastic to that of individual securities.
The reason behind the relative inelasticity is that the market fundamental often tends to affect both of the securities similarly. This makes the margin required for future spread trading to be less than the sum of the margin required for the two individual legs.
A spread trader is a commercial agent that forms the link between hedger and the speculator. Rather than the parties assuming the risk of massive price fluctuation, the spread trader will take the the risk between the two related options in the different markets.
This can also be defined as the difference between equity and an index or between two equities. Generally, the spread trader will engage in trading spreads between the strongest sector and the weakest one.
How to Trade Spreads
Spreads are traded using various commercial methods.
Intra Market Spreads (Calendar Spreads)
Intra Market spreads investments in a commercial situation where a spread trader purchases future contracts of the same products for one month and then sold for another month. A typical example of this is heating oil longs for the month of Novembers sold for heating oil short for the month of February.
The intra market spreads trading is the most common form of spread trading in the market. Most of the spread trades on most exchanges qualify for lower margin requirements and lower commission rates. Spread traders use the Intra Market spreads to make a decision to make revenue on the future direction of prices.
The intra market spread is also used in rolling over a company position from one month to another. The commercial term for this is ‘Interdelivery spread’.
Intermarket spreads are the purchasing simultaneously future contracts of a given month of a given delivery month and simultaneously selling the same future contracts of the same delivery month. This is in the hope of the spread trader that the purchase price is less than the selling price.
Spread traders favor their long-term position compared to their short-term position. This is based on the hope that there will be an increase in price in the long-term period and a fall in the prices in the short-term period of trading.
Inter-Exchange Spreads is a type of spread in which a spread trader purchase a future contract with a specific delivery month and simultaneously puts the future contracts for sale with a same delivery month but this time on a different exchange.
Inter-Exchange spreads are less common compared to the other types of spreads.
What are spread trading?
Spreading is a very conventional way of trading. Inside analysis of trading of spread trading reveals, that speeding safer compared to trading naked future contracts. Spread trading has many advantages compared to naked future contracts trading.
Spreading requires less considerable margin (usually 25 % – 75 %) for absolute future positions. Spreads are also more trending compared to outright future positions. This makes spreading to have relatively more returns on investment compared to total futures points.
Another advantage is that it is possible to use spreads in creating partial futures positions. Anything that can be possibly done with options on futures can be done through spread trading.
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January 17, 2012 | by John Greener |