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finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
, a spread trade (also known as relative value trade) is the simultaneous purchase of one
security" \n\n\nsecurity.txt is a proposed standard for websites' security information that is meant to allow security researchers to easily report security vulnerabilities. The standard prescribes a text file called \"security.txt\" in the well known locat ...
and sale of a related security, called legs, as a unit. Spread trades are usually executed with
options Option or Options may refer to: Computing *Option key, a key on Apple computer keyboards *Option type, a polymorphic data type in programming languages *Command-line option, an optional parameter to a command *OPTIONS, an HTTP request method ...
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. Spreads are either "bought" or "sold" depending on whether the trade will profit from the widening or narrowing of the spread.


Margin

The volatility 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 may refer to: Physical or graphical edges * Margin (typography), the white space that surrounds the content of a page *Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust *Leaf ...
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.


Types of spread trades


Intracommodity (Calendar) spreads

Calendar spreads are executed with legs differing only in delivery date. They price the market expectation of
supply and demand In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris paribus, holding all else equal, in a perfect competition, competitive market, the unit price for a ...
at one point in time relative to another point.http://chicagofed.org/digital_assets/publications/understanding_derivatives/understanding_derivatives_chapter_1_derivatives_overview.pdf A common use of the calendar spread is to "roll over" an expiring position into the future. When a
futures contract In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
expires, its seller is nominally obliged to physically deliver some quantity of the underlying
commodity In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. The price of a co ...
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 spread Crack spread is a term used on the oil industry and futures trading for the differential between the price of crude oil and petroleum products extracted from it. The spread approximates the profit margin that an oil refinery can expect to make by ...
between crude oil and one of its byproducts, reflecting the premium inherent in refining oil into gasoline, gas oil, or heating oil * The spark spread between natural gas and electricity, for gas-fired power stations * The crush spread between soybeans and one of its byproducts, reflecting the premium inherent in processing soybeans into soy meal and soy oil * Highly correlated instruments such as Brent Crude vs WTI Crude or London White Sugar vs New York Sugar.


Option spreads

Option spreads are formed with different option contracts on the same underlying
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a compan ...
or
commodity In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. The price of a co ...
. 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 In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between t ...
attempts.


IRS (Interest rate swap) spreads

Not to be confused with
Swap spread Swap spreads are the difference between the swap rate (a fixed interest rate) and a corresponding government bond yield with the same maturity ( Treasury securities in the case of the United States). For example, if the current market rate for a f ...
s,
IRS The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory tax ...
Spread trades are formed with legs in different currencies but the same or similar maturities. Two notable examples, U.A.E. Dirham and Saudi Riyal interest rate swaps, are quoted in the inter-bank market as spreads to US dollar interest rate swaps. AED and SAR currency exchange rates are each pegged to the USD, hence their interest rate swap markets are highly correlated to the US interest rate swap market respectively. e.g. if the SAR IRS Spread for a 5-year maturity is quoted as +150 basis points and the USD 5 year IRS fixed rate is trading at 1.00%, where the IRS fixed payments are annual and the floating payments are quarterly LIBOR, then the SAR 5 year IRS fixed rate will be 2.50%.


See also

*
Bucket shop (stock market) A bucket shop is a business that allows gambling based on the prices of stock, stocks or commodities. A 1906 U.S. Supreme Court ruling defined a ''bucket shop'' as "an establishment, nominally for the transaction of a stock exchange business, or b ...
* Contract for difference * Forex * Financial betting * Spread betting *
Yield spread Yield may refer to: Measures of output/function Computer science * Yield (multithreading) is an action that occurs in a computer program during multithreading * See generator (computer programming) Physics/chemistry * Yield (chemistry), the amo ...


References

{{reflist Financial markets