Also called straddling, spread trading is a strategy designed to reduce risk, but one that still allows the trader every chance of making a decent gain if a correct decision has been made.
When trading any financial instrument, risk is always inherent.
A particular instrument is usually able to produce a gain or loss for the investor, depending on which way the market in that instrument moves. This places all the risk in one instrument.
The alternative is to trade two or more instruments, by taking a position in one and the opposite position in the other.
This means that the market movement upward or downward is not being traded; it is the relationship between two instruments that is traded. They could both move upward or downward, and this is not of concern, for it is their differential that is pertinent in spread trading.
For instance, one may purchase a debt instrument that by definition is really lending money at a certain interest rate. If interest rates go up, to redeem the investment, borrowing or selling of the instrument would have to occur at a higher rate. In this case a loss is incurred.
The only manner in which a profit could have been made is if interest rates declined and the borrowing or selling took place at a lower interest rate. Clearly, it is a demanding position.
However, if the investor wished to reduce risk and still take a view on the market that interest rates would fall, an alternative is to purchase the debt instrument as was already done, and sell or borrow in another related debt instrument. Because they are different but similar instruments, they will likely have different prices and maturity dates. For this reason, it is no longer the direction of the market that is being traded, but the differential relationship between the two.
If for example the first instrument makes a gain of £1000, then because the opposite was taken on the other instrument one would expect a loss, due to the fact that they were like instruments. This loss is deducted from the profit on the first.
Ideally, if the relationship has moved favorably for the investor, the gain will outperform the loss. If the relationship has gone against the investor the loss would outperform the gain.
Still, any loss incurred will be far less than that of an outright position, and similarly, any gain incurred will also be far less than an outright position.
Of course, the interesting feature of spread trading is that it is always possible that both the investments may move in opposite directions. This can be hugely satisfying if in the correct direction, but earth shattering if in the adverse manner.
However, the fact that the two are like and similar instruments is most likely to indicate that this scenario is not going to manifest.
Some relationships are closer than others, so the closer the relationship between the two; the more likely they track each other in unison as in the instance of a 90 day bill and a 50 day bill. This is why less risk is present.
Other relationships are not as close, and offer more risk, as is exampled by a 90 day bill and a 2 year bond. The same principle of risk and reward applies; the higher the risk, the greater the reward if correct, but spread trading is an effective method of trading differentials and reducing risk without outright market exposure.
Spread trading using unrelated investments is of no value and is likened to outright positions in both instruments.
This article was provided by the money and debt expert Fred Ballentine who works for http://www.IVA.net. If you need help contact them today.