Spread trading isn’t difficult to understand if you remember that it’s centered on the time-worn adage of markets: Buy low, sell high.
Spread trading is a strategy of gauging how the price difference between two securities or contracts—the spread—will change. A spread trader is focused more on the price difference and less on the prices themselves.
Spread trading explained
Spread trading is simply identifying the difference in price between two securities or other assets and then attempting to profit from a widening or narrowing of that gap. A spread trade is typically a short-term strategy.
Spread trading also is called relative value trading, because it’s rooted in the assumption that one security is overvalued relative to the other. A spread trading strategy thus combines a simultaneous sale of the security the investor thinks is overvalued (short position), with a purchase of a related security thought to be undervalued (long position). The long and short positions are referred to as legs.
Futures and options contracts often are used to establish a spread trade. For example, energy or agricultural futures would be used in a commodity spread trade, and index futures for broad stock market spread trades. Options generally are used for a spread trade on a particular stock.
Exchanges such as the Chicago Mercantile Exchange offer some spreads as a package—a trading unit including both legs with matched notional (underlying dollar) values. The prices on these spread units are separately quoted from the underlying futures—for example, if December corn futures are quoted at 520 cents ($5.20) per bushel and December wheat is quoted at 580 cents, the corn/wheat spread would be 60 cents.
The investor’s goal is for the spread to narrow or widen, depending on how the spread trade was set up. For example, a commodity investor who thought corn prices were undervalued relative to wheat would buy a long corn/short wheat spread and expect the difference to narrow if corn prices rose, wheat prices fell, or both.
Investors shouldn’t confuse spread trading with financial spread betting, which is simply a speculative bet on whether a security’s price will rise or fall, without a purchase or short sale of the security and without a margin requirement. The bet is placed with a broker, who takes the opposite side of the bet. It’s akin to betting on point spreads for sports games—and it’s illegal in the US, as well as in Japan and Australia. Spread betting is allowed in the UK and some parts of Europe.
Spread trading examples
The following are some spread trading examples.
Also called a calendar spread, an intramarket spread is done mainly with futures contracts in the same commodity with a different expiration (delivery) months. The investor buys a contract for a given commodity to be delivered in Month 1 and sells another contract for the same commodity in Month 2.
For example, the investor enters a soybean spread trade that involves buying a contract for $11.75 a bushel for November delivery, and selling a contract for $12.05 for January delivery. This establishes a spread of 30 cents a bushel. If the spread narrows, the investor’s trade is profitable. If it widens, the investor loses on the trade.
An intermarket spread involves buying in one market or type of security and selling in a related market or type of security.
In commodities, this spread would buy and sell two related types of futures markets—such as energy with energy or grain with grain.
For example, an investor could buy a December crude oil contract and sell a December natural gas contract. The spread trade would be profitable if the crude price rose or the gas price fell, before the futures delivery date.
A more important example in energy markets is the so-called crack spread, or difference between the price of a barrel of crude oil and the equivalent price of refined products such as gasoline and jet fuel. It’s a basic gauge for profit margins of refining companies, so they frequently trade crack spreads to hedge against rising crude oil costs.
In the stock market, index spreads are made using index futures contracts or exchange-traded funds. Equity index and ETF spreads are constructed by the investor who buys and sells futures in a ratio that gives each a roughly equal dollar value.
One prominent example of an index spread is the S&P 500 against the Nasdaq 100. Someone who is bullish on the S&P might buy S&P futures and sell Nasdaq futures. Let’s say S&P 500 futures, which are the index times a multiplier, are priced at about $100,000, and Nasdaq 100 futures are priced at about $50,000. For every S&P futures bought, two Nasdaq futures would be sold, to create the spread trade.
Equity index and ETF strategies are also sometimes called pairs trades. Pairs trading generally requires two things that have a high correlation—that is, two indexes or ETFs that have some historical price relationship or pattern. This can also be done with two stocks. An investor would want to trade pairs when the pattern has diverged—when the price of one is rising or the other is falling, moving away from the pattern. In the pairs trade, the rising security would be sold and the falling security bought as the investor bets the securities will revert to the historical pattern.
Spread trading stocks provides an array of possibilities. An investor can create different combinations of call and put options with different exercise prices and expirations.
For example, Company Z is trading at $175 a share in November. An investor with a short-term bullish view could:
- Sell a December call with a $185 strike price for $3.50 ($350 for a 100-share contract).
- Buy a January $185 call for $6 ($600 for one contract).
The investor’s net cost for this option spread using different expiration months is $2.50 a share, or $250 (the difference between $350 and $600). This is cheaper than buying the January call alone. The investor then hopes that the spread between the two option premiums widens, either by the December call declining from $3.50 or the January call increasing from $6, or both. If the December call drops to $2, for example, the investor can buy one to cover the short, or if the January call rises to $8, the investor can sell one. The spread trade profit then becomes $3.50 ($8 - 6 + 3.50 - 2).
In the bond market, spread trading in U.S. Treasury securities focuses on the difference in yields between different bonds based on their time to maturity. The yields for the various key maturities in the Treasury bond market, ranging from three months to 30 years, when plotted on a chart are known as the yield curve. The curve typically slopes upward, from left to right, from shorter to longer maturities.
Bond traders bet on the shape of that slope–on changes in relative interest rates—through buying and selling Treasury bond futures. For example, the so-called 2/10 spread is often cited in financial markets as the yield difference between two-year and 10-year Treasury securities.
An investor who thinks the yield difference will narrow—that the yield curve will flatten or rise less steeply—will sell the 2/10 spread, meaning they will sell the two-year Treasury and buy the 10-year. The opposite applies if the investor thinks the 2/10 spread will widen—the yield curve will steepen. The investor will buy the spread, meaning they’ll buy the two-year Treasury and sell the 10-year.
Interest-rate spread trades also can be created with eurodollar futures. Eurodollars are three-month dollar deposits held in banks outside the US. The futures are deliverable quarterly from three months to 10 years, creating a spectrum of maturities similar to the U.S. Treasury yield curve.
Inter-exchange spread trading involves the same security or commodity, traded on different exchanges. Examples include wheat traded on the Chicago Board of Trade versus wheat on the Kansas City Board of Trade.
Potential advantages of spread trading
For more sophisticated investors, spread trading may have a number of pluses. These include:
- Spreads usually have less volatility than the futures or options themselves, thus lower risk.
- Lower risk means lower margin requirements—less money is needed to enter a spread trade than to buy futures contracts outright. For options spreads, the premium collected for selling an option can offset or exceed the premium cost of buying the other option.
- Lower margin requirements can mean higher returns.
- It can be easier to exploit price discrepancies via the spread than to predict price movements in each underlying security or contract.
- A spread trade can make money in a rising or declining market. It’s a market-neutral strategy.
Potential drawbacks of spread trading
There are potential risks and expenses associated with spread trading. These include:
- Potential returns are limited to the relative movements of the spread. A spread trade might mean the investor misses out on an opportunity to take advantage of a longer trend.
- The trade can go wrong, causing losses. The long position may decline or the short position rise—or both.
- Transaction costs are higher in futures spreads, as each leg of the trade using futures has a cost.
The bottom line
Some spread trades are readily available on exchanges as prepackaged products, such as commodity spreads and interest-rate spreads. Investors should develop an understanding of the price history and patterns in markets, before considering spread trades. As tools to hedge a portfolio, by protecting gains or minimizing losses, they can be useful. Used for speculation, they can be risky.