What is a Spread Trade?
A spread trade occurs when an investor simultaneously buys and sells two related securities that are bundled as a single unit. Each of the transactions is referred to as a 'leg.'
How Does a Spread Trade Work?
The purpose of a spread trade is to net a profit from the difference in the two legs -- known as the spread. Futures and options typically form the legs of a spread trade.
Spread trades are executed as a single unit on futures exchanges in order to A) ensure that the completion of the trade is perfectly synchronized, B) eliminate the risk of one leg failing to execute, and C) take advantage of the narrowing or widening of the spread -- as opposed to the direct price fluctuations of the legs.
There are three common types of spread trades: Calendar, intercommodity and option spreads. Calendar spreads are executed based on the expected market performance of a security on a given date, versus its performance at another point in time. An example is the market comparison of September orange juice futures and October orange juice futures.
Intercommodity spreads reflect the economic relationship between two different but comparable commodities. An example of an intercommodity spread would be the historic relationship between gold and platinum prices.
An option spread is formed by buying and selling the same stock at different strike points. Option spreads can be complex, with their colorful names adding to the complexity (iron butterfly, iron condor, etc). To learn more about option spreads, click here to read A How-to Guide to the Iron Butterfly & Other Option Spread Strategies.
Why Does a Spread Trade Matter?
The spread trade is a way for investors to take advantage of market imbalances. Traders can use a relatively small upfront investment to make a big profit. Spread trades can also be used as a conservative hedging strategy by lowering portfolio volatility, reducing bias and even earning income.
