spread trade
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In
finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the left corn ...

finance
, a spread trade (also known as relative value trade) is the simultaneous purchase of one
security Security is freedom from, or resilience against, potential Potential generally refers to a currently unrealized ability. The term is used in a wide variety of fields, from physics Physics is the natural science that studies matter, its El ...
and sale of a related security, called legs, as a unit. Spread trades are usually executed with options or
futures contracts In finance, a futures contract (sometimes called futures) is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usual ...
as the legs, but other securities are sometimes used. They are executed to yield an overall net position whose value, called the spread, depends on the difference between the prices of the legs. Common spreads are priced and traded as a unit on
futures exchanges A futures exchange or futures market is a central financial exchange An exchange, bourse (), trading exchange or trading venue is an organized market where (especially) tradable securities A security is a tradable financial asset. The term ...
rather than as individual legs, thus ensuring simultaneous execution and eliminating the
execution risk In economics and finance, arbitrage (, ) is the practice of taking advantage of a price difference between two or more Market (economics), markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the ...
of one leg executing but the other failing. Spread trades are executed to attempt to profit from the widening or narrowing of the spread, rather than from movement in the prices of the legs directly. Spreads are either "bought" or "sold" depending on whether the trade will profit from the widening or narrowing of the spread.


Margin

The volatility of the spread is typically much lower than the volatility of the individual legs, since a change in the
market fundamentals Market may refer to: *Market (economics) *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an island shared by Finland and Sweden Art, entertainment, and media Films *Market (1965 film), ''Market'' (1965 ...
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.


Types of spread trades


Intracommodity (Calendar) spreads

Calendar spread In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
s are executed with legs differing only in delivery date. They price the market expectation of
supply and demand In microeconomics Microeconomics is a branch of that studies the behavior of individuals and in making decisions regarding the allocation of and the interactions among these individuals and firms. Microeconomics focuses on the study ...

supply and demand
at one point in time relative to another point.http://chicagofed.org/digital_assets/publications/understanding_derivatives/understanding_derivatives_chapter_1_derivatives_overview.pdf A common use of the calendar spread is to "roll over" an expiring position into the future. When a
futures contract In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money availabl ...
expires, its seller is nominally obliged to physically deliver some quantity of the underlying
commodity In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plan ...
to the purchaser. In practice, this is almost never done; it is far more convenient for both buyers and sellers to settle the trade financially rather than arrange for physical delivery. This is most commonly done by entering into an offsetting position in the market. For example, someone who has sold a futures contract can effectively cancel the position out by purchasing an identical futures contract, and vice versa. The contract expiry date is fixed at purchase. If a trader wishes to hold a position in the commodity beyond the expiration date, the contract can be "rolled over" via a spread trade, neutralizing the soon to expire position while simultaneously opening a new position that expires later.


Intercommodity spreads

Intercommodity spreads are formed from two distinct but related commodities, reflecting the economic relationship between them. Common examples are: * The
crack spread Crack spread is a term used on the oil industry and futures contract, futures trading for the differential between the price of crude oil and petroleum products extracted from it. The spread approximates the profit margin that an oil refinery can ...
between crude oil and one of its byproducts, reflecting the premium inherent in refining oil into gasoline, gas oil, or heating oil * The
spark spread The spark spread is the theoretical gross margin of a gas-fired power plant from selling a unit of electricity, having bought the fuel required to produce this unit of electricity. All other costs (Business operations, operation and Maintenance, rep ...
between natural gas and electricity, for gas-fired power stations * The
crush spread A crush spread is a commodity trading strategy in which the Trader (finance), trader takes a Long (finance), long position in soybean Futures contract, futures against Short (finance), short positions in soybean meal futures and soybean oil futures ...
between soybeans and one of its byproducts, reflecting the premium inherent in processing soybeans into soy meal and soy oil * Highly correlated instruments such as Brent Crude vs WTI Crude or London White Sugar vs New York Sugar.


Option spreads

Option spread Options spreads are the basic building blocks of many options strategies, options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different st ...
s are formed with different option contracts on the same underlying
stock In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities i ...

stock
or
commodity In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plan ...
. There are many different types of named option spreads, each pricing a different abstract aspect of the price of the underlying, leading to complex
arbitrage In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behav ...
attempts.


IRS (Interest rate swap) spreads

Not to be confused with
Swap spread Swap spreads are the difference between the swap rate (a fixed interest rate) and a corresponding government bond yield with the same maturity (United_States_Treasury_security#Treasury_bond, Treasury securities in the case of the United States). Fo ...
s,
IRS The Internal Revenue Service (IRS) is the revenue service A revenue service, revenue agency or taxation authority is a government agency responsible for the intake of government revenue, including taxes and sometimes non-tax revenue. ...
Spread trades are formed with legs in different currencies but the same or similar maturities. Two notable examples, U.A.E. Dirham and Saudi Riyal interest rate swaps, are quoted in the inter-bank market as spreads to US dollar interest rate swaps. AED and
SAR SAR or Sar may refer to: Places * Sar (river) The Sar is a river in Galicia, Spain. Rising near Santiago de Compostela, it flows through the A Maía valley for over before entering the Ulla (river), Ulla River, near Padron. Pomponius Mel ...
currency exchange rates are each pegged to the
USD The United States dollar (symbol A symbol is a mark, sign, or word In linguistics, a word of a spoken language can be defined as the smallest sequence of phonemes that can be uttered in isolation with semantic, objective or pragma ...
, hence their interest rate swap markets are highly correlated to the US interest rate swap market respectively. e.g. if the SAR IRS Spread for a 5-year maturity is quoted as +150 basis points and the USD 5 year IRS fixed rate is trading at 1.00%, where the IRS fixed payments are annual and the floating payments are quarterly LIBOR, then the SAR 5 year IRS fixed rate will be 2.50%.


See also

*
Bucket shop (stock market) A bucket shop is a business that allows gambling based on the prices of stocks or commodities. A 1906 U.S. Supreme Court ruling defined a bucket shop as "an establishment, nominally for the transaction of a stock exchange business, or business of s ...
*
Contract for difference In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...

Contract for difference
* Forex * Financial betting * Spread betting * Yield spread


References

{{reflist Financial markets