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
While spread trading is considered to be a strategy in itself, there are a number of variations of this strategy that traders employ based on the specifics of the security they are looking to trade. Let’s look at some of these spread trade strategies.
The inter commodity spread
As part of this spread trading strategy, the trader will spread trade two commodities that, on the surface, appear to vary on several fronts. However, there exists some relationship between the two which causes the trader to pick the two securities. One might also note that a similar concept exists when companies expand upwards or downwards, however for this instance, it is employed from the traders side.
An example could be the relationship between a french fries manufacturer and the cultivation of potatoes. In this instance, while the industries these commodities exist in vary greatly (a french fries manufacturer engages in more consumer-centric functions in the secondary and tertiary sectors whereas potato cultivation belongs more in the primary sector), there is a direct link between the two. The prices of potatoes will potentially subsequently increase the price and therefore reduce the demand for french fries. Additionally, a trader could also pick a potato manufacturer and a fast food outlet that serves price, and a similar relationship would exist.
The option spread
This strategy involves the trader picking two varying options as different ‘legs’. While the options vary in this strategy, both options have to be related to similar security in the spread trade meaning that there must still be some link maintained between the two options.
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.
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.