Spread trading is a strategy used by forex traders, commodity traders, and equity traders to profit from the difference between the buying and selling prices of two related assets or securities. Rather than speculating on the direction of price movement, spread trading focuses on the price relationship between two instruments, such as currency pairs, commodities, or stocks. Traders aim to profit from the changes in the spread between these related instruments.

The concept of spread trading can be applied in various markets, and it is often considered a market-neutral strategy because it doesn’t rely on the price movement of one individual asset. Instead, it exploits price differences between two assets or instruments. This makes spread trading appealing to traders looking for low-risk opportunities in volatile markets.

What is a Spread?

In trading, the spread refers to the difference between the ask price (the price at which a trader can buy) and the bid price (the price at which a trader can sell) of an asset. In forex, this spread is usually measured in pips and represents the cost of executing a trade.

For example, in a currency pair like EUR/USD, if the ask price is 1.2005 and the bid price is 1.2000, the spread is 5 pips. The spread is a key factor that traders must consider when entering a trade, as it affects the profitability of their position.

In spread trading, the term “spread” also refers to the difference in price between two related assets. Traders aim to profit from changes in this price difference, rather than speculating on the individual price movements of the assets.

How Spread Trading Works

Spread trading involves two main types: intramarket spread trading and intermarket spread trading.

1. Intramarket Spread Trading

Intramarket spread trading, also known as a vertical spread in options trading, involves buying and selling different contracts (such as options or futures contracts) for the same underlying asset but with different maturities, strike prices, or expiry dates. The goal is to profit from the difference in price movement between these contracts.

Example in Forex:

In forex, intramarket spread trading can be done by taking positions in two different contract months for the same currency pair. For instance:

• Buy a long position in EUR/USD for the near month (current contract).
• Sell a short position in EUR/USD for the next month (future contract).

The trader profits from the difference in price changes between these two positions over time, without taking a directional bet on the EUR/USD currency pair itself. The strategy is effective when the trader believes that the price difference between the two contracts will widen, rather than focusing on the price movement of the EUR/USD pair itself.

2. Intermarket Spread Trading

Intermarket spread trading involves trading two different but related instruments, such as two currency pairs, commodities, or stocks. The goal is to take advantage of changes in the price differential (spread) between these instruments. Traders expect the spread between the two assets to widen or narrow based on market conditions, news, or other fundamental factors.

Example in Forex:

In forex, intermarket spread trading might involve trading two related currency pairs, such as EUR/USD and GBP/USD. For example:

• Buy EUR/USD and Sell GBP/USD.

The trader is betting that the spread (the difference in price movement) between these two pairs will widen or contract based on their analysis of the underlying market forces.

How to Execute a Spread Trade

1. Choose Two Related Assets: Select two assets that are correlated or have a relationship in terms of price movement. In forex, this could involve related currency pairs like EUR/USD and GBP/USD, or USD/JPY and EUR/USD.
2. Take Opposite Positions: Take a long position (buy) in one asset and a short position (sell) in the other. The positions should be sized appropriately to manage risk and capital. In forex, this would typically mean buying one currency pair and simultaneously selling another.
3. Monitor the Spread: Keep track of the price difference between the two positions. Your goal is to profit from changes in the spread, either by the spread widening (if you are long on the spread) or narrowing (if you are short on the spread).
4. Exit the Trade: Exit the trade when the spread has reached a favorable level, either through your own analysis or a pre-set target. The positions may be closed when the price differential has moved in your favor.

Example of Spread Trading in Forex

Imagine you are a forex trader who believes that the EUR/USD currency pair will strengthen relative to GBP/USD. To implement this view using spread trading, you would:

• Buy EUR/USD: You expect that the EUR will perform better than the USD.
• Sell GBP/USD: You expect that the GBP will underperform relative to the USD.

In this scenario, you are betting that the EUR/USD pair will strengthen more than the GBP/USD pair, thus causing the spread between the two pairs to widen. If the price difference increases, you can close both positions for a profit.

Advantages of Spread Trading

1. Lower Risk Exposure: Since spread trading doesn’t rely on the price movement of one asset, it can be considered a market-neutral strategy. This helps reduce exposure to market risk, particularly in volatile markets.
2. Profit from Market Inefficiencies: Spread traders can profit from inefficiencies in the market or price discrepancies between correlated instruments. These opportunities often arise due to factors like differing liquidity, volatility, or market sentiment.
3. Diversification: Spread trading allows traders to take positions across different markets or assets, providing diversification within a single strategy.
4. Can Be Used for Hedging: Spread trading can be an effective hedging strategy, allowing traders to offset potential losses in one position by taking an opposite position in a related market.

Disadvantages of Spread Trading

1. Transaction Costs: Spread trading involves multiple trades (buying and selling), which means higher transaction costs, including spreads and commissions. These costs can eat into potential profits, especially if the spread does not move in your favor.
2. Complexity: Spread trading requires a solid understanding of the relationship between the assets involved, and it may require advanced knowledge of technical and fundamental analysis. For beginners, this strategy can be more challenging to execute successfully.
3. Limited Profit Potential: While spread trading is a lower-risk strategy, the profit potential is also more limited compared to directional trading, where traders can profit from large moves in the market.
4. Requires Constant Monitoring: Spread trades need to be monitored closely to ensure the spread is moving in the desired direction. In some cases, you may need to adjust or close positions based on changing market conditions.

Conclusion

Spread trading is an advanced strategy that allows traders to profit from the price relationship between two related assets, such as currency pairs, commodities, or stocks. It offers a way to profit from market inefficiencies with lower risk exposure, but it requires careful analysis, proper risk management, and the ability to monitor multiple positions. While it may not be as straightforward as directional trading, spread trading can be an effective strategy for traders looking to capitalise on price movements without taking a strong directional bet.