If you’re new to investing and have come across the terms ‘spread trading’ or ‘relative value trading’, and wanted to understand all about it; you’ve come to the right place. What follows is a detailed look at what spread trading strategies exactly mean, what are the various types, and some spread trading tips for beginners.
What are spread trading strategies?
Spread trading or relative value trading is a trading method in which an investor buys a security and simultaneously sells a related security. The securities involved in this process are known as ‘legs’ in common parlance. These are often executed through futures contracts or options. However, other securities can also be opted for.
The objective of spread trading strategies is to earn from changes in the spread or the price difference between two securities. The spread narrows or widens and provides an opportunity for monetary advantage. There are numerous types of spreads. Let us look at the types before jumping into spread trading tips. The major, broad categories are as follows:
Options spread: Options spreads are made with options contracts as the legs of the spread trade. In this case, it is necessary for both the contracts to belong to the same commodity or security type. There are two kinds of options, put options and call options.
Call options come with the facility of buying into the future. Put options allow you to sell into the future. Thus, if you buy a call option of a certain company and sell another call option of the same company simultaneously, you open a spread trading position.
Generally, spreads involve a minimum two-leg order. They can also involve multi-leg option orders such as the ‘butterfly spread option’ strategy. The difference between expiry dates or strike prices of the two options is known as spread. It is advisable to utilize a range of combinations of strike prices and expiration dates for this purpose.
Inter-commodity spread: An inter-commodity spread is one in which you buy and sell commodities that are distinguished and different but related at the same time. There is usually an economic connection between both commodities. Based on this principle, the types of inter-commodity spread are bifurcated.
A crush spread refers to the kind of relationships that exist between a specific manufacturing product and its byproducts.
A spark spread refers to the relationship between two industries wherein both require similar raw materials or other sources for their operations.
A crack spread refers to the relationship emerging out of the value of processing one product into another in an industry.
To get involved in inter-commodity spread training, you need a solid understanding of
different optioned commodities in the market. Not just this, you also need to have a
grasp of the dynamics between these different commodities and industries you’re dealing with. Generally, inter-commodity spread trading is not advisable for traders who are inexperienced or are just starting out.
Now that you have a lowdown of the two major kinds of spread trading strategies, you can keep exploring this knowledge domain further before jumping into the actual business. Now, let us look at some spread trading tips for beginners.
Spread trading tips for beginners
Smaller players in the market don’t trade spreads often because there is a higher complexity involved in terms of analysis of relative demand and supply components of the two contracts and not just overall demand and supply. And yet, spreads intrigue small speculators to a great extent since if traded in the right manner, they can provide a lot of potential with significantly low volatility.
Hence, it is very important to conduct your research about the securities that you are expecting to trade Be on the lookout for earnings announcements and other relevant financial data that could have an impact on the trade. Keep abreast with the latest charts and the news. Plus, you must have heard of one of the unsaid golden rules of investing which also applies here — don’t depend on technical analysis only. Fundamentals have the potential to make or break your investments.
One of the most important spread trading tips to keep in mind is that you must begin on a small scale. Remember to start even smaller than you think you can manage to. The reason is that you might make certain mistakes in the beginning and cause your leverage to start working against you. You must, therefore, absolutely know what you’re getting into and make carefully calculated decisions. The solution is to acquire a deeper understanding and a hands-on experience with lesser amounts first and then play the bigger game.
Track the market
Markets mostly move in the initial thirty to sixty minutes of the trading session, especially once the American markets open. Trading during this window should be a factor of your risk-absorbing capacity. Play only in the sectors which are known to you and which you have a good understanding of. If you aren’t properly updated on the companies you’re supposed to track or cannot comprehend the factors impacting your position, then it is almost akin to gambling. Ensure that you are fully aware of and recognize the value of your chosen market segment.
Another crucial part of spread trading tips is to know how to formulate strategies that carry lower risks. Spread trading generally carries lower volatility because of the hedged nature of the positions. Because of this, you can put up lesser margin money along with exchanges. Basically, spread trading could provide you with a more lucrative risk/reward ratio as compared to an outright position.
Trying new, different, and exciting things is a natural tendency when you have just begun with investing in the market. But you must’ve heard enough stories about investors having to pay a lot for what could be called ‘rookie mistakes’, even after they’ve been in the field for a long time. Hence, before trying something like a spread strategy, make sure that you do much more research after this article and give it your best, calculative shot!