The Intermarket Spread Strategy is a trading approach that involves taking opposite positions in two related markets or asset classes to profit from the price difference or spread between them. This strategy exploits market correlations, interest rate differentials, and economic relationships between two or more instruments. The goal is to capitalise on inefficiencies in the pricing relationship between markets, such as commodity prices versus currencies, equity indices versus futures, or bond yields versus currency pairs.

The strategy is widely used by institutional traders, hedge funds, and proprietary trading desks due to its ability to provide market-neutral profits while diversifying risk across different asset classes.

What Is Intermarket Spread Trading?

Intermarket Spread Trading involves taking long and short positions in two related but different markets that tend to move together. The premise is that if one market moves in a way that deviates from its historical relationship with another market, there is an opportunity to profit when the spread between the two returns to its historical average.

Some typical examples of intermarket relationships include:

• Commodity and Currency Correlations: For example, the Canadian Dollar (CAD) is often positively correlated with oil prices because Canada is a large oil exporter. A trader might take a long position in oil futures and a long position in USD/CAD if they believe oil prices will rise.
• Equity Index and Futures Correlations: Traders might look to profit from the relationship between S&P 500 futures and the SPDR S&P 500 ETF (SPY), where they expect the spread between the two to narrow or widen.
• Bond and Currency Pair Correlations: Interest rate differentials between the U.S. and other countries can create relationships between bond yields and currency movements. For example, the EUR/USD pair is influenced by the yield spreads between U.S. Treasuries and Eurozone bonds.

Strategy Components

1. Identifying Related Markets

The first step in executing an intermarket spread strategy is to identify two related markets that are highly correlated. These might be:

• Currencies vs. Commodities (e.g., AUD/USD vs. gold)
• Equity Indices vs. Futures (e.g., S&P 500 vs. S&P 500 futures)
• Interest Rate Products vs. FX (e.g., US Treasury yields vs. USD/JPY)

Traders typically use historical data to determine the strength of the correlation between two assets. A correlation coefficient near +1 suggests a strong positive relationship, while a correlation near -1 suggests a strong negative relationship.

2. Establishing the Spread

The spread in an intermarket strategy is the price difference or relative value between two assets. The spread can be measured in terms of:

• Price difference: For example, the price of a commodity futures contract minus the price of a related currency pair.
• Volatility difference: The difference in implied volatility or realised volatility between two markets.
• Yield difference: For bonds, the difference in interest rates or yields between two countries.

The trader aims to enter a position when the spread is expected to converge or diverge from the historical average, depending on their view.

3. Long and Short Positions

Traders establish positions in both markets to capture profit from the change in the spread:

• Long position in the outperforming asset (the one expected to rise relative to the other).
• Short position in the underperforming asset (the one expected to fall relative to the other).

For example, if a trader expects gold to rise while expecting the Australian Dollar (AUD) to depreciate against the U.S. Dollar (USD), they could:

1. Go long in gold futures.
2. Go short in AUD/USD (expecting the Australian Dollar to weaken).

4. Monitoring Spread Movements

• Traders monitor the spread’s movement over time to determine the optimal entry and exit points.
• Spreads can either narrow or widen depending on macroeconomic factors, such as central bank policies, commodity price changes, or geopolitical events.
• The trader will close the positions when the spread reaches a predefined target or when market conditions change.

5. Exit Strategy

The exit strategy is based on the expectation that the spread will return to its historical mean:

• Profit-taking: Close both positions when the spread reaches the target profit level.
• Stop-losses: Set a maximum loss level if the spread moves unfavourably, indicating the spread relationship might not converge as expected.
• Rolling the positions: In case the spread is not converging or diverging as anticipated, traders may choose to roll their positions to the next expiration date.

Example: Gold vs. AUD/USD Calendar Spread

Let’s say a trader expects gold to rise, and AUD/USD to fall, based on rising gold prices and a strong U.S. Dollar. Here’s how the strategy might unfold:

1. Long Position: Buy gold futures at $1,800 per ounce.
2. Short Position: Sell AUD/USD at 0.7350, expecting a decline in the Australian Dollar relative to the U.S. Dollar.

As gold rises in price (to $1,850), and the Australian Dollar weakens (AUD/USD drops to 0.7250), the trader profits from both positions, as the spread between gold and the Australian Dollar has widened.

Exit Strategy:

• Profit: The trader closes both positions when the gold price rises to their target level and the AUD/USD falls to the desired level, realising profits from the change in the spread.
• Stop-loss: If gold falls or the AUD/USD rises unexpectedly, the trader exits to cut losses.

Tools and Technologies

• Correlation analysis tools: Use platforms like Bloomberg Terminal, Reuters Eikon, or Excel with built-in correlation functions to track relationships between different markets.
• Trading platforms: Interactive Brokers, MetaTrader 5, or TradingView for executing positions in the spot market or futures market.
• Backtesting software: QuantConnect, Backtrader, or NinjaTrader to test intermarket strategies using historical data.

Advantages

• Market-neutral: The strategy does not rely on the direction of the markets but rather on the relationship between them.
• Profit from inefficiencies: Capitalises on pricing inefficiencies that arise due to changes in correlations or market conditions.
• Diversification: Traders can apply this strategy across multiple markets, diversifying risk across assets such as commodities, currencies, and equity indices.

Limitations

• Complexity: Requires a good understanding of intermarket relationships and how they evolve over time.
• Market risk: The strategy assumes that historical correlations will hold, which may not always be the case in rapidly changing or volatile markets.
• Transaction costs: Spread trading can incur higher transaction costs due to the need for taking multiple positions across different markets.

Best Markets for Intermarket Spread Trading

• Gold (XAU/USD) and AUD/USD: Due to the close relationship between gold prices and the Australian Dollar.
• Oil and CAD (USD/CAD): Oil has a strong positive correlation with the Canadian Dollar.
• S&P 500 futures and SPY ETF: Exploit inefficiencies between the S&P 500 futures market and the corresponding ETF.
• Treasury futures and USD/JPY: Due to the relationship between U.S. Treasury yields and the Yen.

Conclusion

The Intermarket Spread Strategy allows traders to profit from the changing relationships between related markets, such as commodities and currencies or equity indices and futures. By taking positions in both markets and capitalising on inefficiencies or changes in correlations, traders can create profitable opportunities. However, the strategy requires a deep understanding of market dynamics and careful monitoring of intermarket relationships to be successful.

To learn how to implement intermarket spread strategies, backtest models, and trade across multiple markets, enrol in the expert-led Trading Courses at Traders MBA.