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A spread trade involves buying a security and selling another identical or related security as part of one simultaneous transaction to benefit from market imbalances. Though complex and not familiar to the average retail investor, spread trades reduce investment risk as well as generate profit. With all of the different trading strategies available, how do you know if spread trading is suitable for you? Let’s break it down to find out. A financial advisor can help you decide which investment tactics are most appropriate given your financial goals, timeline and and risk profile.

What is Spread Trading?

In the world of finance, you may encounter several different definitions of a spread. But the similarity between all of the definitions is that a spread involves a variation in rates, yields or security prices. When referring to spread trading or relative value trading, someone is referencing a sell-and-buy transaction of a single security, executed as one trade. In other words, the buying and selling of a security are happening at the same time.

Usually, you will find spread trading with futures and options contracts. The offsetting transactions of the two deals are often denoted as the legs of the trade, the ones being bought and sold by the investor. The goal of a spread trade is to yield a positive value, which is the spread of the transaction. When engaging in a spread trade, investors must determine if they will benefit more from a narrow or wider spread in order to reap the best positive value.

One of the reasons why spread trades are sometimes more attractive than straight futures trades is that the margin requirements for spread trades are usually less than for straight futures trades.

Understanding Spread Trading

Bars of silver

The objective of spread trading is to leverage short and long positions against an index, which requires estimating an outcome and taking risks based on that estimate. Since trades are based on the assumption of an investor, spread trading can be both profitable and risky. If an investor’s assumption is correct, then the more profitable they will be. Conversely, the more it’s incorrect, the more the investors can lose. The more accurate an investor’s assumption is, the more profitable it will be. Conversely, the more it deviates, the greater the possible loss.

Each type of investment strategy comes with its perks. Among them, spread traders benefit from one of the most valuable gifts – time. Whether it’s weeks or minutes, an investor can open a position for as long as they need to make the trade. How long they wait depends both on their confidence level and the varying factors they have to monitor. The main factor that determines their trade time is the security’s price, whether it’s above or below where they opened the position.

There is more than one trade action as well. For example, you have bull and bear calls which occur when the investor takes a short position on a security. Alternatively, there are the similarly titled bull and bear puts where the investor takes a long position. Each trader has different approaches to minimizing their risk, with some setting strike prices on their options to cap potential gains and losses. Although, you tend to find this in more advanced options trading strategies.

Types of Spread Trades

There are several types of spread trading which include the following:

Inter-Commodity Spread Trading

Investors who engage in inter-commodity spread trading are trading commodities that have an economic relationship. Some relationship examples include:

  • A spark spread. This spread relates to the relationship concerning natural gas and electricity. Some power plants need natural gas to run; thus, this need creates an intrinsic connection.
  • A crush spread. This spread relates to the relationship concerning soybeans and their derivatives. Because soybeans are used to create oil or meal, this creates an intrinsic connection.
  • A crack spread. This spread relates to the relationship concerning oil and its various petroleum derivatives. For example, since crude oil can be used to make gasoline this creates an intrinsic connection between crude oil and gasoline.

Options Spread Trading

Option spread trading is when the legs of a trade are various options contracts that have either the same security or community. There are different variations of options spread trading that usually require complex investment strategies.

IRS Interest Rate Swap Spread Trading

This spread trading strategy involves currency as the legs while the currency used has either similar or the same maturities. IRS interest rate swap spread trading shouldn’t be confused with swap spreads, which are the estimated variance among the yields on U.S. Treasuries and the interest rates on money swap contracts.

Bottom Line

Man engaged in commodity trading

A spread trade is an investment tactic that entails going long one security while going short the identical security or a similar security. It’s typically done with futures or options contracts and with currency pairs. Traders and investors pursue spread trades as a conservative hedging strategy in the futures markets. It is also done to reduce portfolio volatity, lower bias and sometimes earn income. Whether spread trading seems up your alley or not, keep in mind that every investment strategy has risks and rewards. So, before you engage in spread trading, make sure the investment decision supports your financial objectives.

Tips for Investors

  • You don’t have to create those solutions all on your own. You can work with a knowledgeable financial professional who knows how to address your concerns and needs. Finding the right advisor for you isn’t difficult, either. Using SmartAsset’s matching tool, you can find professionals in your area for free within minutes. To find the financial advisor who can help you obtain your financial goals, get started now.
  • Whether you’re considering getting started with investing or highly experienced, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency and amount of contributions plus risk tolerance can affect how your money grows.
  • You can take many avenues and strategies when it comes to investing, but you need a stable financial situation first. That includes more than just having a stable income. Consider creating an emergency fund that you can fall back on or try to minimize your current debt. Both will help save you money now that you can put towards your long-term goals, like your retirement savings, which you should regularly check on.

Photo credit: ©iStock.com/pixinoo, ©iStock.com/Olivier Le Moal, ©iStock.com/Prostock-Studio

Ashley Kilroy Ashley Chorpenning is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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