What Is Spread Trading?
Spread trading is a popular technique used to make money in open markets while managing risk. Spread trading is less risky than outright speculation in single futures position but still requires careful analysis and can result in a loss.
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Identification
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A spread trade is one in which two offsetting positions are entered, usually one long and one short, with profitability being determined by change in the difference between the two. Common spreads use futures contracts of different months in a single commodity, or two related equities.
Types
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For the sake of clarity, spreads are identified by various terms. Intracommodity spreads consist of one long and one short position in futures contracts of a single commodity. This can also be referred to as a seasonal spread if it takes advantage of predictable annual price fluctuations. In an intercommodity spread, one commodity is played long against a short position in another, usually in contracts of the same expiration. Spread betting is a trading practice popular in the United Kingdom that is similar to spread trading, using derivative products without owning the underlying commodities.
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Strategies
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Though the basic concept is rather simple, some spread trading strategies can be quite complex. Using options, a spread in a single asset can have directionality, meaning it profits by moves in a particular direction, or it can profit if prices remain steady and within a given range. Some advanced strategies, such as the butterfly and the condor, use multiple strike prices to reduce risk and generate small returns.
Benefits
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Using spreads transfers some of the risk associated with trading. Since each position is offset, or hedged, the trader is not exposed to direct price changes, but to the spread between the positions, which is usually less volatile. As a result, spread trades usually have lower margin requirements. Also, because spread trades tend to be of intermediate-term duration, they do not require the same time-consuming attention and real-time quotes characteristic of day trading.
Considerations
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Transaction costs are a major consideration in spread trading because multiple vehicles usually are traded at once. Entering trades can also be difficult, requiring a trader to "leg in" one position at a time. Depending on the derivatives or vehicles used to effectuate the trade, spread trading positions occasionally can be illiquid. Spread trading usually has limited profit potential as a result of its reduced risk.
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