Spread trade

Last updated

In finance, a spread trade (also known as relative value trade) is the simultaneous purchase of one security and sale of a related security, called legs, as a unit. Spread trades are usually executed with options or futures contracts as the legs, but other securities are sometimes used. They are executed to yield an overall net position whose value, called the spread, depends on the difference between the prices of the legs. Common spreads are priced and traded as a unit on futures exchanges rather than as individual legs, thus ensuring simultaneous execution and eliminating the execution risk of one leg executing but the other failing.

Contents

Spread trades are executed to attempt to profit from the widening or narrowing of the spread, rather than from movement in the prices of the legs directly. [1] Spreads are either "bought" or "sold" depending on whether the trade will profit from the widening or narrowing of the spread. [2]

Margin

The volatility of the spread is typically much lower than the volatility of the individual legs, since a change in the market fundamentals of a commodity will tend to affect both legs similarly. The margin requirement for a futures spread trade is therefore usually less than the sum of the margin requirements for the two individual futures contracts, and sometimes even less than the requirement for one contract.

Types of spread trades

Intracommodity (Calendar) spreads

Calendar spreads are executed with legs differing only in delivery date. They price the market expectation of supply and demand at one point in time relative to another point. [3]

A common use of the calendar spread is to "roll over" an expiring position into the future. When a futures contract expires, its seller is nominally obliged to physically deliver some quantity of the underlying commodity to the purchaser. In practice, this is almost never done; it is far more convenient for both buyers and sellers to settle the trade financially rather than arrange for physical delivery. This is most commonly done by entering into an offsetting position in the market. For example, someone who has sold a futures contract can effectively cancel the position out by purchasing an identical futures contract, and vice versa.

The contract expiry date is fixed at purchase. If a trader wishes to hold a position in the commodity beyond the expiration date, the contract can be "rolled over" via a spread trade, neutralizing the soon to expire position while simultaneously opening a new position that expires later.

Intercommodity spreads

Intercommodity spreads are formed from two distinct but related commodities, reflecting the economic relationship between them.

Common examples are:

Option spreads

Option spreads are formed with different option contracts on the same underlying stock or commodity. There are many different types of named option spreads, each pricing a different abstract aspect of the price of the underlying, leading to complex arbitrage attempts.

IRS (Interest rate swap) spreads

Not to be confused with Swap spreads, IRS Spread trades are formed with legs in different currencies but the same or similar maturities.

Two notable examples, U.A.E. Dirham and Saudi Riyal interest rate swaps, are quoted in the inter-bank market as spreads to US dollar interest rate swaps. AED and SAR currency exchange rates are each pegged to the USD, hence their interest rate swap markets are highly correlated to the US interest rate swap market respectively. e.g. if the SAR IRS Spread for a 5-year maturity is quoted as +150 basis points and the USD 5 year IRS fixed rate is trading at 1.00%, where the IRS fixed payments are annual and the floating payments are quarterly LIBOR, then the SAR 5 year IRS fixed rate will be 2.50%.

See also

Related Research Articles

<span class="mw-page-title-main">Derivative (finance)</span> Financial contract whose value comes from the underlying entitys performance

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.

<span class="mw-page-title-main">Commodity market</span> Physical or virtual transactions of buying and selling involving raw or primary commodities

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

<span class="mw-page-title-main">Contango</span> Situation when futures prices are above the expected spot price at maturity

Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity. In a contango situation, arbitrageurs or speculators are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.

In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).

In finance, the style or family of an option is the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options—as well as others where the payoff is calculated similarly—are referred to as "vanilla options". Options where the payoff is calculated differently are categorized as "exotic options". Exotic options can pose challenging problems in valuation and hedging.

<span class="mw-page-title-main">Futures contract</span> Standard forward contract

In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.

<span class="mw-page-title-main">Forward contract</span> Agreement to sell or buy a good at a specific time and price

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded.

<span class="mw-page-title-main">Hedge (finance)</span> Concept in investing

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.

<span class="mw-page-title-main">Swap (finance)</span> Exchange of derivatives or other financial instruments

In finance, a swap is an agreement between two counterparties to exchange financial instruments, cashflows, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

In finance, an interest rate derivative (IRD) is a derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.

An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset. It is a particular type of interest rate derivative.

Crack spread is a term used on the oil industry and futures trading for the differential between the price of crude oil and petroleum products extracted from it. The spread approximates the profit margin that an oil refinery can expect to make by "cracking" the long-chain hydrocarbons of crude oil into useful shorter-chain petroleum products.

An energy derivative is a derivative contract based on an underlying energy asset, such as natural gas, crude oil, or electricity. Energy derivatives are exotic derivatives and include exchange-traded contracts such as futures and options, and over-the-counter derivatives such as forwards, swaps and options. Major players in the energy derivative markets include major trading houses, oil companies, utilities, and financial institutions.

The Malaysia Derivatives Exchange (MDEX), also known as Malaysian Distribution Exchange, is a limited share company formed during June 2001 in Malaysia through the merger of the Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) and the Commodity and Monetary Exchange of Malaysia. It is a subsidiary of the Kuala Lumpur Stock Exchange (KLSE).

The following outline is provided as an overview of and topical guide to finance:

A commodity broker is a firm or an individual who executes orders to buy or sell commodity contracts on behalf of the clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial derivatives. Clients who trade commodity contracts are either hedgers using the derivatives markets to manage risk, or speculators who are willing to assume that risk from hedgers in hopes of a profit.

<span class="mw-page-title-main">Option (finance)</span> Right to buy or sell a certain thing at a later date at an agreed price

In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset price, time until expiration, market volatility, the risk-free rate of interest, and the strike price of the option. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, public markets in the form of standardized contracts.

LCH is a British clearing house group that serves major international exchanges, as well as a range of OTC markets. The LCH Group consists of two subsidiaries: LCH Ltd and LCH SA. Based on 2012 figures, LCH cleared approximately 50% of the global interest rate swap market, and was the second largest clearer of bonds and repos in the world, providing services across 13 government debt markets. In addition, LCH clears a broad range of asset classes including: commodities, securities, exchange traded derivatives, credit default swaps, energy contracts, freight derivatives, interest rate swaps, foreign exchange and Euro and Sterling denominated bonds and repos.

References

  1. ↑ Spread Order, archived from the original on 2 December 2008, retrieved 17 September 2009
  2. ↑ Dominguez, Javier (20 April 2020). "Spread strategies". Warsoption.com. Retrieved 14 May 2020.
  3. ↑ http://chicagofed.org/digital_assets/publications/understanding_derivatives/understanding_derivatives_chapter_1_derivatives_overview.pdf [ bare URL PDF ]
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.