Spread trade
Encyclopedia
In finance
, a spread trade is the simultaneous purchase of one security
and sale of a related security, called legs, as a unit. Spread trades are usually executed with options
or futures contracts as the legs, but other securities are sometimes used. They are executed to yield an overall net position whose value, called the spread, depends on the difference between the prices of the legs. Common spreads are priced and traded as a unit on futures exchanges rather than as individual legs, thus ensuring simultaneous execution and eliminating the execution risk of one leg executing but the other failing.
Spread trades are executed to attempt to profit from the widening or narrowing of the spread, rather than from movement in the prices of the legs directly.
of the spread is typically much lower than the volatility of the individual legs, since a change in the market fundamentals of a commodity will tend to affect both legs similarly. The margin
requirement for a futures spread trade is therefore usually less than the sum of the margin requirements for the two individual futures contracts, and sometimes even less than the requirement for one contract.
s are executed with legs differing only in delivery date. They price the market expectation of supply and demand
at one point in time relative to another point.
A common use of the calendar spread is to "roll over" an expiring position into the future. When a futures contract
expires, its seller is nominally obligated to physically deliver some quantity of the underlying commodity
to the purchaser. In practice, this is almost never done; it is far more convenient for both buyers and sellers to settle the trade financially rather than arrange for physical delivery. This is most commonly done by entering into an offsetting position in the market. For example, someone who has sold a futures contract can effectively cancel the position out by purchasing an identical futures contract, and vice versa.
The contract expiry date is fixed at purchase. If a trader wishes to hold a position in the commodity beyond the expiration date, the contract can be "rolled over" via a spread trade, neutralizing the soon to expire position while simultaneously opening a new position that expires later.
Common examples are:
or commodity
. There are many different types of named option spreads, each pricing a different abstract aspect of the price of the underlying, leading to complex arbitrage
attempts.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a spread trade is the simultaneous purchase of one security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
and sale of a related security, called legs, as a unit. Spread trades are usually executed with options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
or futures contracts as the legs, but other securities are sometimes used. They are executed to yield an overall net position whose value, called the spread, depends on the difference between the prices of the legs. Common spreads are priced and traded as a unit on futures exchanges rather than as individual legs, thus ensuring simultaneous execution and eliminating the execution risk of one leg executing but the other failing.
Spread trades are executed to attempt to profit from the widening or narrowing of the spread, rather than from movement in the prices of the legs directly.
Margin
The volatilityVolatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
of the spread is typically much lower than the volatility of the individual legs, since a change in the market fundamentals of a commodity will tend to affect both legs similarly. The margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
requirement for a futures spread trade is therefore usually less than the sum of the margin requirements for the two individual futures contracts, and sometimes even less than the requirement for one contract.
Calendar spreads
Calendar spreadCalendar spread
In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring another date...
s are executed with legs differing only in delivery date. They price the market expectation of supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
at one point in time relative to another point.
A common use of the calendar spread is to "roll over" an expiring position into the future. When a futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
expires, its seller is nominally obligated to physically deliver some quantity of the underlying commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
to the purchaser. In practice, this is almost never done; it is far more convenient for both buyers and sellers to settle the trade financially rather than arrange for physical delivery. This is most commonly done by entering into an offsetting position in the market. For example, someone who has sold a futures contract can effectively cancel the position out by purchasing an identical futures contract, and vice versa.
The contract expiry date is fixed at purchase. If a trader wishes to hold a position in the commodity beyond the expiration date, the contract can be "rolled over" via a spread trade, neutralizing the soon to expire position while simultaneously opening a new position that expires later.
Intercommodity spreads
Intercommodity spreads are formed from two distinct but related commodities, reflecting the economic relationship between them.Common examples are:
- The crack spreadCrack spreadCrack spread is a term used in the oil industry and futures trading for the differential between the price of crude oil and petroleum products extracted from it - that is, the profit margin that an oil refinery can expect to make by "cracking" crude oil .In the futures markets, the "crack spread"...
between crude oil and gasoline, reflecting the premium charged to refine oil into gasoline - The spark spreadSpark spreadThe spark spread is the theoretical gross margin of a gas-fired power plant from selling a unit of electricity, having bought the fuel required to produce this unit of electricity...
between natural gas and electricity, for gas-fired power stations
Option spreads
Option spreads are formed with different option contracts on the same underlying stockStock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
or commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
. There are many different types of named option spreads, each pricing a different abstract aspect of the price of the underlying, leading to complex arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
attempts.