Trade Spreads

A trade spread is when you buy and sell two similar securities simultaneously. The main objective is to assess the price difference between two securities, also known as the spread, and benefit from that difference.

Trade spreads also known as relative value trading are an investing strategy used to minimize risk in a portfolio. This trading strategy also makes it possible to calculate the amount of money you’re risking beforehand. There is often a tradeoff with trade spreads, however, which is that in a bid to minimize risk, you may also minimize gains.

Understanding Trade Spreads

Before getting into trade spreads, let’s define what a spread is. A spread is the difference between two similar securities. The difference being measured could include yields, interest rates, or stock prices among others.

The gap between two securities is often referred to as either a narrow or wide spread. When a security has high demand and volume, the spread is usually narrow. When the reverse happens, the spread tends to be wider. The good thing is investors can benefit from both narrow and wide spreads.

In terms of how trade spreads work, when you buy and sell two similar securities simultaneously, that purchase usually creates a spread. The goal is to sell one security that you think is undervalued, also known as the long position and one you think is overvalued, also known as a short position. Long and short positions are commonly referred to as legs. The price difference between the long and short positions is the spread.

Types of Spreads

Trade spreads are often used in future and options trading. They can also be used in multiple types of markets be it bullish, bearish, or sideways as well as across different asset classes. There are different types of spread strategies an investor can try and here are a few.

Bid-Ask Spread
In sum, the gap between a stock’s bid and ask price is the bid-ask spread. For example, if a stock’s bid price or what people are willing to pay for it is $25 and the ask price or what people are selling it for is $26, the bid-ask spread or difference would be $1.

Bid-ask spreads can be a way to gauge how liquid a stock is or how easily it can be sold. Typically, the larger the spread, the less liquid the asset is. Options, Forex, futures contracts and the stock market all use bid-ask spreads.

Yield Spread
This type of spread focuses on measuring differences in bonds. It measures the difference between the yields of two bonds with the same maturity–the date a bond issuer has to return the bond’s face value back to an investor.

As an example, let’s say you had a 20-year U.S. Treasury bond and a 20-year corporate bond. If the former had a yield of 1.50% and the latter had a yield of 5.75%, the yield spread would be 4.25%.

Options Spreads
With this strategy, option contracts are used as legs to create a trade spread. For those unfamiliar with options contracts, they’re an investing strategy where an investor can buy or sell a stock at a predetermined time and at a set price. Options-based spreads may be ideal for investors attempting to get above-average returns when spreads are profitable.

Risks And Benefits

Trade spreads can be complicated and as with every investment, they carry some risk. However, the main disadvantage is that an investor may not get high returns. That aside, trade spreads can help balance your portfolio, which can be helpful when your investments or the market are volatile.

To get the most out of this investing strategy, consider contacting a financial professional from our team to find out how they can help you achieve your goals using spreads.