Spread Trading

Share Trading has come a long way from times when people would shout out prices to buy and sell stocks on the trading floor. The trading process has become swift and efficient, where traders can employ various strategies.

Traders have developed multiple trading techniques via experience, trial, and error, to harness market opportunities. Spread trading is one such technique. This article will help us learn spread trading and its types.

What is spread trading?

Spread in the stock market is the difference between two rates, prices, or yields. Spread trading is a type of trading that involves buying and selling two financial instruments at the same time. The two instruments can be anything from stocks and bonds to currencies, commodities, futures, and options.

For example, in the case of Futures trading, spread can involve buying one or more futures contracts and simultaneously selling one or more to optimize the risks and returns.

Suppose you buy Nifty Dec Futures at Rs. 18,000 and sell Nifty Jan Futures at Rs.18,010. Here, your spread is 10, and you believe the spread to shift so you can make a profit.

Let us assume that after a few days, the Nifty Dec Futures go up to Rs. 18,015 and the Nifty Jan Futures go up to Rs. 18,017. Now, if you close the position, you make a profit of Rs. 15 on Nifty Dec Futures and a loss of Rs. 7 on Nifty Jan Futures. Thus, you have made a profit of Rs. 8 on this future spread.

Options Spread

With this approach, the trader selects two options as “legs”. The trader takes position in the same type of option – either Call or Put of the same underlying asset. The strike price and expiration date may differ.

Spread trading is advantageous as the traders’ gains or losses are determined by changes in the spread rather than changes in the prices of the underlying assets.

Here, the futures/options/securities bought and sold are called “legs”. Investors’ prime objective is to exploit the spread itself as a way to generate profit.

Spread trading is a way to hedge positions. If done properly, it could be profitable.

What are the types of spread trading strategies?

There are many kinds of spread trading strategies and we describe a few options-based spreads here:

Calendar Spreads

In calendar spread, a trader buys either a call or a put option, one with an expiry date in the near term and one with an expiry date far in the future.

Vertical Spreads

A vertical spread can be created with either all the Call options or all the Put options with the long option and short option at two different strike prices. All options have the same expiry date.

Collar Spreads

In Collar spread, traders shorts a Call option, long a Put option, and further takes a long position in a stock.

Conclusion

For some investors, spread trading may be a significant part of their overall investment plan, but it can also get challenging to manage. Spread trading may transition from largely basic hedging into speculating when leverage is added. Indeed, a lot of traders only employ spread trading for speculative purposes.

Thus, for investors contemplating spread trades, it is critical to understand the distinction between hedging and speculating. Also, thorough research is required in the spread trade to get the most out of it.