Spread trading – also known as relative value trading – is a method of trading that involves an investor simultaneously buying one security and selling a related security. The securities being bought and sold, often referred to as “legs,” are typically executed with futures contracts or options, though there are other securities that can be used.
Spread trading – also known as relative value trading – is the simultaneous buying and selling of related securities as a unit, designed to profit from a change in the spread (price difference) between the two securities.
The primary goal for investors is to use the spread itself as a way to generate profit when the spread widens or narrows.
There are a variety of types of spreads and spreads with names; the most common types of spreads are option spreads and inter-commodity spreads.
Strategy and Purpose of Spread Trading
The strategy of spread trading is to yield the investor a net position with a value (or spread) that is dependent upon the difference in price between the securities being sold. In most cases, the legs are not traded independently but instead, are traded as a unit on futures exchanges.
The goal for investors is to make a profit off the spread as it gets wider or grows narrower. With spread trading, investors aren’t generally looking to benefit from direct price movements of the legs themselves. Spreads – because they are executed as a unit – are either bought or sold. It depends on the investor’s needs as to whether he believes he will benefit from a wider or narrower spread.
Two Common Types of Spreads
There are several types of spreads; however, the two most common are inter-commodity spreads and options spreads.
1. Inter-commodity spread
The inter-commodity spread is created when an investor buys and sells commodities that are decidedly different, but also related. An economic relationship exists between the commodities. For example:
A crush spread is the relationship between soybeans and their byproducts, which reflects the importance of processing soybeans into oil or meal.
A spark spread is a relationship between electricity and natural gas; there are many power stations that require gas for fuel.
A crack spread is a relationship between oil and its byproducts, with the spread showing the inherent value of refining crude oil into gas.
2. Option spread
Another common spread is option spread. Options spreads are created with different option contracts as legs. Both contracts must pertain to the same security or commodity.