Spread trading is a relatively old strategy of approaching the financial market. It is also a wide method that has several moving parts. In this article, we will look at what spread trading is and how you can use it successfully in the market.
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What is a spread?
A spread is defined as the difference between two things in the market. The most popular definition of a spread is the difference between the bid and ask prices. A bid price is the maximum price that a trader is willing to buy an item for while ask is the maximum price that a seller is willing to sell.
Let’s use this example.
You go to the market to buy a shirt and you find one that you love. The seller quotes the shirt at $20, which is now the ask price. Since the price is negotiable, you quote your best price at $17. In this case, the difference between the two is known as the spread.
Indeed, spreads are so important in the market such that it is how most brokers make money. If you are finding a forex and CFD broker, you will realize that all of them don’t charge a commission. Instead, they make their money in form of the spread.
As such, you should pay close attention to the spread when you are looking for an online broker.
There are other definitions of spreads in the market. For example, in the futures market, a spread can be defined as the differences between two periods. For example, if the June contracts for crude oil are trading at $55 and those of July are trading at $60, the spread, in this case, is $5.
Types of spreads in the market
We have looked at two main types of spreads in the financial market. But there are more, including:
- Merger spread – This is a spread that emerges when there is a merger and acquisition transaction. In this case, the stock of the company being acquired usually rises while that of the acquirer tends to fall. The difference between these is known as spread.
- Credit spreads – In bonds trading, a credit spread is a difference between the yield of two bonds with a similar maturity. For example, if the three-year bond is yielding at 5% and the ten-year corporate bond is yielding 8%, the difference is the credit spread.
- Inter-commodity spread – This is the spread between commodity prices and assets that are related to the commodity. For example, crush spread shows the difference between soybeans and soy oil products.
- Intra market spread – This is a spread that we described above where the futures of an asset is priced differently.
- Inter-exchange spread – This happens when a similar asset is priced differently in different exchanges. For example, the price of Brent could be $50 at broker A and $50.50 at broker B.
Calculating the spread
Calculating the spread of two assets is significantly simple since it refers to the difference between two assets.
For example, if Brent is trading at $80 and West Texas Intermediate (WTI) is at $77, the spread is $3. Similarly, if the 10-year bond yield is trading at 2.0% and the 30-year is at 2.5%, then the spread is 0.5%.
Types of spread in assets
There are other types of popular spreads in other markets. First, there is a bond spread, which refers to the difference between two bond yields. For example, one of the most closely watched spreads in the bond market is the 10-year treasuries for Italy and Germany.
In Europe, Italy is seen as a riskier country because of its substantial national debt. Germany is a safe country in fiscal terms. Therefore, a wide Italian and German bond spread is usually a sign that investors are worried about the bloc.
Second, in the United States, the difference between the short and longer-dated government bonds is known as the yield curve. A normal curve happens when short-term bonds have a smaller yield than longer-dated one. An inverted curve happens when short government bonds have a bigger yield than long ones.
Third, there is the spread between different crude oil benchmarks like Urals, Brent, and West Texas Intermediate. For example, a thinning spread between Brent and WTI can imply that the oil market is getting tight.
How to use spread trading in the financial market
There are several approaches to using the spread trading strategy. Let us look at several of them.
Similar Assets
First, you can focus on financial assets that tend to move in the same direction. For example, the price of Brent and West Texas Intermediate (WTI) usually move in the same direction. Also, Brent is usually more expensive than WTI.
Therefore, this means that the difference between the two prices produces the spread. As such, there’s a way you can make money in this situation.
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For example, if you believe that the price of oil will rise, you can buy a certain amount of Brent and then short WTI. The implication of this is relatively simple. If the price of oil rises, you will make money through your Brent trade and lose money in your WTI trade. Your profit, in this case, will be the difference between the two financial assets.
Spread in the futures market
Second, you can use spread trading in the futures market. A good example is the so-called gold bull spread. In this case, you can buy 2021 CME January gold futures at $1,475 and then sell one lot of July 2020 gold futures at $1,485.
In this case, the profit will be if the January futures rise faster than the July futures. The spread between the two is 15.
Different assets that move together
Third, you can even use the spread between two different assets that usually move together. A good example in this is the Nasdaq 100 index and the Invesco QQQ ETF. The two usually move together because they are essentially made of the same assets in the same allocation.
Spread trading in forex
Spread trading can also be used in forex trading. Indeed, the forex trading industry is usually made up of spreads since brokers only make money from the spread. There are several ways of doing this. But the most popular is known as arbitrage or pairs trading, where you buy and sell two currency pairs and benefit from the spread.
Some traders also do this with the same currency pair where they buy a pair and short a separate amount of the same pair. In this case, your profit will be the difference between the profit and loss that you make.
It is worth noting that a currency pair’s bid and ask spread often changes based on market conditions. For example, spreads tend to thin when there is no volatility and then expand when the market is seeing extraordinary volatility.
Summary
Spread trading is a wide approach to trading financial assets where you take advantage of the difference between prices. You can use it both in the spot prices and the futures market.
While it usually has limited risks, things can go wrong. For example, there could be a divergence in the prices of two correlated assets.
External Useful Resources
- Spread Trading Strategies: Different Strokes for Different Folks – TDAmeritrade