What is Spread Trading?

The global capital markets are not just a place where directional trades are taken. In the global marketplace, it is the institutions that are predominant players and most of the institutions have internal stipulations on risk management and compliance. While these institutions are willing to commit larger capital, their risk appetite is lower and that is where spread trading comes in. as the name suggests, spread trading entails trading a spread or a price difference rather than the asset directly.

By default, spread trading meaning is to trade the spread or difference between prices. Hence, the spread trading definition is about a focus on tracking the movement of this spread rather than asset prices. Let us now look at what is spread trading and how it makes sense to the trader.

Spread Trading

Spread trading is defined as the sale of one or more futures contracts and the simultaneous purchase of one or more offsetting futures contracts. The beauty of spread trading is that it just tracks the difference between the price and your profits or losses are based on the movement of the spread rather than the movement of the asset prices.

Having understood what is spread trading, let us look at the classes of spread trading.

1. You can trade spread between two contracts. For example, you can buy Nifty June futures and sell Nifty futures.
2. You can trade spread between the basket and the index. For example, you buy a portfolio of stocks in Nifty and simultaneously equivalent Nifty futures
3. Finally, you can do pair trading e.g., spread trading by buying Infosys and selling Hindustan Unilever based on their historical relationship

In the above 3 categories, the first 2 are predictable spreads whereas the last one is just based on empirical relationship and tends to be higher on the risk scale. There are also intraday market spreads like spreads between steel and SAIL or spreads between Hindalco and aluminum or Vedanta and Copper. These are a lot more complex and also error-prone.

Let us now turn to some of the merits of spread trading.

Here are some of the major advantages you can derive as a spread trader. Of course, it may sound surprising but there are occasions when even spreads can go wrong and while you may be eventually correct about mean reversion, the intermittent pressure created by mounting margin pressures and funding shortfalls create practical problems. Now for some of the merits of spread trading.

• One of the big advantages of spread trading is that you don’t have to watch the spread all day long unlike your price charts. You can trade spreads more like long-term delivery positions, without worrying too much about real-time data.
• As a result, spread trading becomes the perfect fit for program traders and other institutional traders that can use computing edge to beat the market by identifying spreads before the market does.
• It is not just stocks but even spreads that follow certain patterns with mean reversion being one of the simplest trades. Some traders believe that trends in spreads are a lot more reliable and consistent as they are derived trends over some time.
• Perhaps, the most important merit of spread trading is that the margins required for spread trading are substantially lower. Hence, although the profits may be lower on spreads, you have the privilege of taking larger positions in the market. This is true of commodities and equity/index spreads also.
• As a trading strategy, spread trading is more conservative and even traders with lower risk appetites and even first-time traders can use this strategy to onboard the derivatives trading market. The risk can be estimated with a greater degree of accuracy.
• Perhaps, the most important aspect of spread trading is that it adds value even in volatile markets when price trading becomes riskier.

What is Arbitrage?

In technical parlance, arbitrage is riskless profit. There are often positions in the market wherein you can take a position and lock in a profit at the point of initiating the trade itself. Remember, not all spread trades offer risk-less profits. They offer a scenario where risk is better managed. A classic example of risk-less profit is cash-futures arbitrage. Let us see how it works.

Assume that you have bought 500 shares of Reliance at Rs.2200. You find that the RIL futures are trading at Rs.2,220 in the near month expiry, which is 20 days away. Here you can create a riskless cash-futures arbitrage spread. Since you have 500 shares of Reliance, you can sell 2 lots of RIL futures at Rs.2,220. On the day of expiry, the stock price and the futures will expire at the same level so the gap of Rs.20 is your assured / riskless profit. That means; the riskless profit percentage is (20/2200) = 0.91%.

Remember this is just profits for one month contract so the annualized return will be around 11%. That is a fantastic return on a risk-less basis as your bank FDs don’t even pay you 6% per annum. That is why this risk-less arbitrage between cash and futures is preferred by a lot of large corporates and institutions to park short-term funds.

How do you calculate the minimum margin?

Effective June 2020, SEBI went live on a new margining framework, which offers deep concessions for spread trading since the risk is limited as compared to plain naked trades. For example, if you do a bull call spread or a bear put spread on the Nifty, your average margin requirement will be nearly 60-65% lower than the normal margin requirement. You are aware that the normal margin requirement in F&O is the total of the SPAN margins plus the exposure margins.

Frequently Asked Questions

What is Bid-ask?

One of the most common measures of the efficiency and liquidity of any market is the bid-ask spread. The bid is the best buy price and the ask is the best sell price. When you sell you must sell at the best buy price and when you buy you must buy at the best sell price. The thumb rule is that thinner this spread, the more efficient is the pricing of the stock or the futures and the lower is the risk for the trader. This gap between the best buy price and the best sell price is called the bid-ask spread and that is normally what the market maker earns as spread for creating liquidity in the markets.

What is an Ideal Spread?

There is nothing like the idea spread as it varies from market to market and from situation to situation. The thumb rule is that lower the spread, the better it is.