Spread Trading

Spread trading means simultaneously buying one instrument and selling a related one, so that profit or loss depends on the difference between their prices, the spread, rather than on the overall direction of the market. Spreads are especially common in futures, where exchanges list them as single tradable products, but the idea applies across markets: pairs of stocks, bonds of different maturities, options at different strikes and currencies. This lesson gives the overview; detailed lessons cover each type.

Why trade spreads?#

• Lower directional risk: the two legs offset much of the market's movement.
• Lower margin: exchanges often charge far less margin for recognised spreads than for single positions. See Futures Margin: Initial and Maintenance.
• Express specific views: for example "summer gasoline will be strong relative to winter" or "short term rates will rise faster than long term rates".
• Exploit economic relationships such as processing margins and storage costs.

Main types of spreads#

Pricing a spread#

Spreads are usually quoted as one leg minus the other. Buying the spread means buying the first leg and selling the second; selling the spread means the reverse. In ratio spreads, the legs are in different quantities, chosen so their values or risks balance, such as the 3:2:1 crack spread (three barrels of crude against two of gasoline and one of heating oil).

What moves spreads#

• Supply and demand timing: harvests, inventories and seasonal demand. See Seasonality in Commodities.
• Storage and financing costs: which determine normal calendar spreads. See Contango.
• Relative fundamentals between related products or companies.
• Interest rate expectations for yield curve spreads.

Risks#

• Spreads can move sharply despite offsetting legs, especially near expiry or in supply shocks.
• Leg risk: if legs are entered separately, prices can move between fills. Exchange listed spreads avoid this.
• Liquidity: deferred months or less common combinations can be thin. See Liquidity.
• Delivery and expiry: the near leg may approach first notice day before the far leg. See First Notice Day and Last Trading Day.
• Low margins can tempt oversizing. Lower margin does not mean no risk.

Common mistakes#

• Treating spreads as risk free.
• Ignoring seasonal norms for the spread.
• Trading illiquid combinations with wide bid ask spreads.
• Forgetting roll and expiry dates for each leg.

Frequently asked questions#

What is spread trading?#

Buying one instrument and selling a related one at the same time to profit from changes in the price difference between them.

Why is margin lower on futures spreads?#

Because the two legs offset much of each other's risk, exchanges recognise the spread and charge lower combined margin.

What is a calendar spread?#

A spread between two contract months of the same product, such as buying December corn and selling March corn.

Next, see how traders try to lock in pricing differences in Arbitrage Strategies.