Next to options trading, spread trading can be one of the most potentially confusing areas of finance. However, the essence of it is fairly simple. Spread trading means buying a futures contract or other type of security and selling another related one in order to profit from the price difference, or “spread” between the two. This is often done to take advantage of predictable seasonal changes in the price of certain commodities. Investors who use the spread trading technique may study historical or technical factors in determining when and how to place trades and where prices are likely to go.
Spread trading falls into three basic categories, the first one being intramarket spreads. This is the simplest type of spread trade and involves buying and selling the same commodity, but for different months. For example, an investor might buy July wheat and sell December wheat. Intermarket spreads are a second type in which different commodities are traded for the same month. An example of this might be buying July wheat and selling July corn. The third type is the inter-exchange spread, where one commodity is traded but on two separate exchanges. For example, an investor might buy July wheat on the Chicago Board of Trade (CBOT), but sell October wheat on the Kansas City Board of Trade (KCBOT). Inter-exchange spreads are less commonly used than the other two types.
There are many commonly used patterns in spread trading, many of them with nicknames that suggest the commodities involved. For example, a Spark spread is a spread trade between natural gas and electricity, and a Crush spread is a spread between soybeans and soybean meal and/or soybean oil. In any spread trade, an investor or trader must concern themselves with whether or not both sets of prices are moving in their favor. The amount of attention and expertise this requires can make these trades somewhat confusing, especially to an inexperienced trader.
Most securities exchanges do not report spread transactions along with other price quotes, although this practice was once common. To get accurate data on current spread trading, it is helpful to have the assistance of a broker who can contact the trading floor for the latest information. Spread trading can have value for some investors, but the cost of working closely with a broker may be prohibitive for some. This factor, as well as all the costs of spread trading, must carefully be considered by the individual investor.
