Spread Trading: A Comprehensive Guide to Relative Value Trading

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 contractsFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price. or options, though there are other securities that can be used.

Summary

• 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 spreadCrack SpreadCrack spread refers to the pricing difference between a barrel of crude oil and its byproducts such as gasoline, heating oil, jet fuel, kerosene, asphalt base, diesel fuel, and fuel oil. The business of refining crude oil into various components has always been volatile from the revenue point of view. 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.

Related Readings

CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)®Program Page - CMSAEnroll in CFI's CMSA® program and become a certified Capital Markets &Securities Analyst. Advance your career with our certification programs and courses. certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Commodity-Linked SecuritiesCommodity Linked SecuritiesCommodity linked securities are investment instruments or securities that are linked to one or more commodity prices. Unlike commodities, which provide no income to the owner, commodity linked securities usually give some payout to holders.
• Options: Calls and PutsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price.
• Trading MechanismsTrading MechanismsTrading mechanisms refer to the different methods by which assets are traded. The two main types of trading mechanisms are quote driven and order driven trading mechanisms
• Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading