Spread Trading

Spread trading is a method of trading in which a position is built from two or more related instruments, one bought and another sold at the same time. The trader's result depends on the change in the difference between their prices, called the spread, and not on whether prices in general rise or fall. The individual sides of the position are called legs.

The technique is used in futures, options, bonds, shares and currencies by speculators, hedgers and arbitrageurs. Because the two legs tend to move together, a spread position is usually less volatile than an outright position in either leg. The term is unrelated to spread betting, a retail product offered in the United Kingdom, and it uses the word in a different sense from the bid-ask spread quoted on a single instrument.

• Calendar spreads. The trader buys a futures contract for one delivery month and sells the same contract for another month. The position expresses a view on storage costs, seasonal supply or the shape of the forward curve, which may be in contango or backwardation. Options have their own calendar spread.
• Inter-commodity spreads. The legs are different but economically linked products. The crack spread sets crude oil against the petrol and heating oil refined from it, and the crush spread sets soybeans against soybean meal and oil.
• Inter-market spreads. The same or a similar product is traded on two venues, such as wheat in Chicago against wheat in Kansas City.
• Yield curve spreads. Bond or interest rate futures of different maturities are traded against each other to express a view on the slope of the yield curve.
• Equity spreads. Two related shares, or a share against an index, are traded against each other, as in pairs trading.
• Option spreads. Options on the same underlying with different strikes or expiries are combined into an option spread.

For two legs, the spread is:

• $P_A$ is the price of the leg that is bought.
• $P_B$ is the price of the leg that is sold.
• $h$ is the hedge ratio, the quantity of the second leg held per unit of the first. For a calendar spread in one commodity it is 1.

A trader who buys the spread profits if it rises, and one who sells it profits if it falls.

Suppose a trader buys July corn futures at $4.50 a bushel and sells December corn futures at $4.70. The spread is $4.50 - 4.70 = -0.20$. Some weeks later July trades at $4.65 and December at $4.75, so the spread is $-0.10$. It has risen by $0.10. On a standard contract of 5,000 bushels the gain is $0.10 \times 5{,}000 = 500$ dollars per spread. The long leg gained $750 and the short leg lost $250. Both prices rose, but only the change in the difference mattered.

Exchanges and clearing houses recognise that the legs of a standard spread offset one another, and they set the initial margin on the combined position well below the sum of the margins on two outright positions. Lower margin means greater leverage for a given amount of capital.

Many exchanges list common spreads as instruments in their own right, with their own order books. An order in such an instrument fills both legs at once at an agreed difference. A trader who instead executes each leg separately faces legging risk: one side may fill while the price of the other moves away.

Some spreads are tied together by a physical or contractual link, such as the cost of storing a commodity between two delivery dates. When prices stray far enough from that link, arbitrage pulls them back. Other spreads rest only on a historical statistical relationship. Traders test whether such a spread tends to return to an average level, using tools such as cointegration, and trade it on the expectation of mean reversion. The second kind carries no guarantee of convergence.

A spread position is lower in risk than an outright one only while the relationship between the legs holds. Spreads can move sharply when supply conditions change, when a contract nears delivery or when one leg becomes illiquid. Because margins are low, traders often hold large positions, and a modest move in the spread can produce a large loss relative to capital. The hedge fund Amaranth Advisors lost about $6 billion in 2006, largely on calendar spreads in natural gas futures.

Costs are doubled, since each spread involves at least two transactions on entry and two on exit. Positions in physically delivered contracts must be closed or rolled before the delivery period. A spread that is hedged with an imperfectly matched instrument is also exposed to basis risk.

• CME Group
• Commodity Futures Trading Commission