What is Spread Trading?

Spread is the difference between the bid (buying price) and the ask (selling price). By understanding what a spread trade is, you can evaluate your overall trade cost or profit. In spread trading, traders aim to exploit the price difference between two or more related assets listed on the exchange. These assets can be stocks, commodities, indices, and more. In this trading strategy, the trader tries to profit from, both, upward and downward price movement while minimising exposure to market risk. Read on to understand what is spread in trading, its types, benefits and more.

Key Highlights

• Spread is the difference between bid and ask prices, and spread trading aims to benefit from price differences between related assets while minimising market risk.

• Types of spreads include intermarket, intra-commodity, inter-commodity, calendar, and options spreads.

• Advantages of spread trading include reduced market direction risk, hedging opportunities, capital efficiency, diversification, and potential for consistent gains in stable market conditions.

• Market volatility, liquidity risk, execution timing, and margin requirements are some of the risks and considerations of spread trade.

Understanding Spread in Trading

In the stock market, spread is the difference between two prices, yields or rates. Spread trading is a type of trading that involves buying and selling two financial instruments simultaneously. The two financial instruments can be anything from stocks and bonds to commodities, currencies, futures and options.

Let us understand this type of trading with an example. So, assume a case of futures trading. Here, the spread can involve buying one or more future contracts and simultaneously selling one or more to optimise the returns and risks. Suppose you buy Nifty Feb Futures at ₹19,000 and sell Nifty Mar Futures at ₹19,010. Here, your spread is ₹10.

Types of Spread Trading

Intermarket, intracommodity, intercommodity, calendar and options are the types of spread trading. Let’s understand each one in detail:

• Intermarket spread: In this spread type, traders execute trade involving related securities across different stock exchanges, such as the NSE and BSE. For example, a trader may simultaneously buy and sell shares of the same company listed on BSE and NSE.

• Intracommodity spread: Here, traders focus on different contract months of the same commodity futures listed on the exchange. A trader might buy a futures contract for a near-month expiry and at the same time sell a contract for a later-month expiry.

• Intercommodity spreads: Traders trade related but different commodities in this type of spread. For example, a trader may trade silver futures against gold futures.

• Calendar spread: This spread type allows the trader to execute trade involving the same stock or commodity with different expiration dates.

• Options spread: Traders can use options contracts to create spread positions. This includes vertical spreads (buying and selling options with different strike prices) or horizontal spreads (buying and selling options with various expiration dates).

Advantages of Spread Trading

This type of trading on the Indian exchanges offers several advantages to the traders. Some of them are:

• Reduced market direction risk: Regardless of the overall market’s direction, traders can profit from price differentials.

• Hedging opportunities: Spread strategies can be used to hedge against potential losses in exiting positions.

• Capital efficiency: Some spread trade may require a lower margin than outright positions, making them capital efficient.

• Diversification: By incorporating different assets or contract months on an exchange, traders can diversify their portfolios.

• Potential for consistent gains: In stable market conditions, traders may generate steady and relatively predictable returns.

Risk Associated With Spread Trade

Before engaging in spread trading, it is important to note some risks and considerations. The following are the risks and considerations associated with this trade:

• Market volatility: If rapid and unexpected market movements are not managed effectively, it can lead to significant losses.

• Liquidity risk: Some trades may involve an illiquid asset or contract on exchange, affecting trade execution and pricing.

• Execution timing: To capture the favourable price differentials, it is important to execute the trade at a precise time.

• Margin requirements: Unfavourable spread movement may lead to margin requirements, necessitating additional capital.

Factors Affecting Spread Trade

Several factors affect the spread of a trade. Below are the key ones:

• Market conditions: When market conditions are favourable, i.e. when many high buyers and sellers exist, the spread tends to be narrow. The reason is that when the market is active with several participations, there is increased competition between buyers and selling. This leads to tighter spreads. On the other hand, during the low market activity, spreads may widen as there are fewer participants.

• Liquidity: When high liquidity exists in the market, the spread is narrow. High liquidity means an active market with a greater number of transactions. Often this increased transaction results in a smaller bid-ask spread. Whereas, low liquidity leads to wider spreads due to reduced trading activity.

• Volatility: When there is high volatility, spreads widen and in low volatility it is narrow. The high market fluctuation leads to uncertainty and risk, causing market participants to widen their bid-ask spread as a form of risk compensation. In contrast, during low volatility, the spread is narrow as market conditions are considered stable.

• Political factors: In the presence of political uncertainty arising from elections, policy changes, or disputes, the spread becomes wider. Political events lead to market uncertainty, prompting traders to adjust their risk expectations. As the market uncertainty increases, the market participant may demand a higher spread to manage the perceived risk associated with political factors.

• Economic factors: Economic indicators and events that indicate economic instability or downturn may lead to wider spreads. In this situation, investors become more risk-averse and contribute to increased bid-ask spreads.

• Creditworthiness: When an issuer with poor creditworthiness releases debt securities, the spread is wider and narrower when the issuer is creditworthy. The reason is that the issuer’s creditworthiness affects the perceived risk associated with their securities. To compensate for the risk, investors may demand a higher spread for securities issued by entities with poor creditworthiness. On the other hand, securities issued by creditworthy entities may have a narrow spread.

Conclusion

Spread trading is a strategy that allows traders to profit from relative price movements between related assets. There are different types of spreads such as inter-market, intra-commodity, inter-commodity, or options spreads. By employing a spread strategy on the exchange, traders can manage market fluctuation, hedge risk and potentially achieve significant gains. However, this type of trading requires thorough analysis, risk management, and an in-depth understanding of Indian market dynamics.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.